Individual taxpayers generally realize gains or losses when they sell capital assets, which are generally defined as properties owned for investment or personal purposes and outside the normal course of a taxpayer’s trade or business. In recent years, IRS studies show that the majority of capital asset transactions and capital gains and losses were for securities transactions, including sales of corporate stock, mutual funds, bonds, options, and capital gain distributions from mutual funds. For example, in 1999, the latest year for which IRS published data on capital assets sales, an estimated 91 percent of capital asset transactions, 62 percent of capital gains, and 79 percent of capital losses were from securities transactions. Also, over the past two decades, individual ownership of securities assets held outside of retirement accounts has increased. According to the Federal Reserve Board, the percentage of families that own stock, mutual funds, and bonds outside of retirement accounts increased from 25 percent in 1983 to a high of 42 percent in 2001, before falling to 38 percent in 2004. When taxpayers sell or otherwise receive income from securities, they must report the transactions on their federal income tax returns. For securities sales, taxpayers are to report the dates they acquired and sold the asset; sales price, or gross proceeds from the sale; cost or other basis of the sold asset; and resulting gains or losses on Schedule D to the individual tax return—Form 1040. Taxpayers are to report this information separately for short-term transactions and long-term transactions. Taxpayers also are to report the total amount of their capital gain distributions from mutual funds, which are always considered to be long-term transactions. Taxpayers are to report their overall gains or losses from securities sales, capital gain distributions, and other capital gains on the Form 1040 tax return itself. Generally, a taxpayer’s gain or loss from a securities sale is simply the difference between the gross proceeds from the sale and the original purchase price, or original cost basis. However, before taxpayers can determine any gains or losses from securities sales, they must determine if and how the original cost basis of the securities must be adjusted to reflect certain events, such as stock splits, nontaxable dividends, or nondividend distributions. For example, figure 1 shows how a taxpayer would need to adjust the basis of a stock following a stock split to accurately determine the resulting capital gain or loss when the stock is sold. In this example, if the taxpayer fails to properly adjust the basis of the stock to account for the split, he or she will incorrectly report a capital loss from the sale. Taxpayers who buy and sell the same stock or mutual fund shares at various times can determine basis in a number of ways. Taxpayers can specifically identify the groups of shares they want to sell. For example, if a taxpayer buys a group of 10 shares of stock in one year for $1 per share and another group of 10 shares of the same stock in the next year for $2 per share, and then sells 10 shares of the stock, the taxpayer can choose to sell the stocks with either the $1 or $2 cost basis. If taxpayers cannot identify which shares they sold among many they bought on varying occasions, they must report the basis of the securities they purchased first as the basis of the sold shares. Except for mutual fund shares, taxpayers cannot use the average cost of securities they purchased at various times to determine basis. When taxpayers sell securities through a broker, that broker is required to file Form 1099-B with IRS and the taxpayers to report a description of the security, sales date, number of shares sold, and gross proceeds from the sale, along with other information. Brokers are not required to report the cost or other basis of the sold security or, with the exception of regulated futures contracts, the resulting gain or loss from a security sale. Capital gain distributions from mutual funds are to be reported on Form 1099- DIV. The rate at which income from securities is taxed depends on how long taxpayers held a security before sale and taxpayers’ regular income tax rates. Securities assets sold after being held for 1 year or less are considered short-term and taxed at the taxpayers’ regular income tax rates. Assets sold after being held for more than 1 year are considered to be long- term and are generally taxed at maximum rates of 5 percent or 15 percent, depending on the taxpayer’s regular income tax rates. Capital gain distributions from mutual funds are always taxed as long-term gains. Taxpayers can deduct capital losses against their capital gains, and any excess losses can be deducted against ordinary income up to a limit of $3,000 ($1,500 for married taxpayers filing separately), beyond which the losses can be carried over to offset capital gains or ordinary income in future tax years. Thirty-eight percent of individual taxpayers who had securities transactions misreported their securities gains or losses for tax year 2001. A greater percentage of taxpayers misreported their securities sales (36 percent) than misreported their capital gain distributions (13 percent), and most of the misreported securities transactions exceeded $1,000 of capital gain or loss. Taxpayers often misreported their capital gains or losses from securities sales because they failed to accurately report the securities’ basis. For tax year 2001, individual taxpayers frequently misreported their capital gains or losses from the securities they sold. Overall, an estimated 8.4 million of the estimated 21.9 million taxpayers with securities transactions misreported their gains or losses. Table 1 shows the estimated percentages of taxpayers who misreported their securities sales and capital gain distributions, overall and by the securities’ holding period. Table 1 shows that a higher estimated percentage of taxpayers misreported a securities sale than a capital gains distribution. Overall, an estimated 7.3 million out of an estimated 20.3 million taxpayers misreported their securities sales compared to the estimated 1.2 million out of an estimated 9.1 million taxpayers who misreported their capital gain distributions. One reason taxpayers may misreport securities sales more frequently is that taxpayers must compute the portion of their sales proceeds that constitutes a gain or loss, whereas taxpayers need only add up their capital gain distributions from information returns they receive and enter the amounts on their tax returns. Table 1 also shows that individual taxpayers are estimated to have misreported their short-term securities sales about as often as their long-term sales. In addition, our analyses showed the following: Of those taxpayers who misreported securities sales, an estimated 97 percent misreported gains or losses from the sales of stocks and mutual funds while an estimated 5 percent misreported bonds, options, or futures. Individual taxpayers misreported securities sales more frequently than other types of income, such as wages and salary, dividend income, and interest income. Respectively, an estimated 10 percent, 17 percent, and 22 percent of taxpayers with these types of income misreported the income. We were not able to estimate the capital gains tax gap for securities because the cases we reviewed included too few misreported securities transactions and taxpayers misreported a wide range of dollar amounts from the transactions, among other reasons (see app. I). However, we were able to determine the direction of the misreporting. For securities sales, an estimated 64 percent of taxpayers underreported their income from securities (i.e., they understated gains or overstated losses) compared to an estimated 33 percent of taxpayers who overreported income (i.e., they overstated gains or understated losses). For both underreported and overreported income, some taxpayers misreported over $400,000 in gains or losses. Also, as shown in table 2, around half of taxpayers who did not accurately report their securities sales were estimated to have misreported at least $1,000 of capital gains or losses (that is, taxpayers not in the less than $1,000 categories). In terms of income levels, the distribution of taxpayers who misreported gains or losses from securities sales and capital gain distributions did not vary greatly from the income level for all individual taxpayers for tax year 2001, as shown in table 3. Based on information in the files we reviewed, a primary type of noncompliance that caused taxpayers to inaccurately report their capital gains or losses from securities sales in tax year 2001 was misreporting the basis of the securities they sold. Table 4 shows the estimated frequency of the types of noncompliance that caused taxpayers to misreport capital gains or losses from their securities sales. For taxpayers who misreported basis, a greater percentage failed to accurately report basis for long-term securities holdings (35 percent of taxpayers who misreported securities sales) than for short-term holdings (21 percent). Taxpayers who failed to report securities sales altogether did not report short-term and long-term securities sales at a similar rate (20 percent and 22 percent, respectively, of taxpayers who misreported securities sales). Although we were able to determine the percentage of taxpayers who failed to accurately report their securities sales because they misreported basis (49 percent), we could not develop reliable estimates on the reasons for this type of misreporting because most of the NRP examination case files did not provide sufficiently descriptive information. However, of the 133 taxpayers who misreported basis from the 849 case files we reviewed, we were able to determine that 32 taxpayers misreported basis for the following reasons: Taxpayers did not have records of their securities purchases (16 taxpayers). Although during examinations, IRS was able to obtain basis records for some of these taxpayers from their brokers, for 9 taxpayers, basis records could not be obtained. For these taxpayers, IRS examiners considered basis to be zero and treated all gross proceeds amounts as capital gains. Taxpayers used original cost basis instead of adjusted cost basis (6 taxpayers). Taxpayers did not understand how to determine basis (5 taxpayers). Taxpayers reported basis information that was incorrectly determined by a tax return preparer (4 taxpayers). One taxpayer reported inaccurate basis information provided by a broker. Of taxpayers who failed to report their securities sales altogether, an estimated 28 percent were estimated to have failed to report capital losses.