Back in 2008, Congress passed a law that included the requirement for brokerages to report the cost basis for the shares that you sell. This means that not only do you have to pick a cost basis before the transaction occurs, but your broker needs to know your choice as well. Stocks had to meet this requirement starting last year, and 2012 is the year that cost basis reporting kicks in for mutual funds.
You have to pick a method of cost basis so that you (and the IRS) know how to figure out your gains, losses and whether they are long or short term. Here are some of the choices you have when picking a cost basis:
- FIFO: This is “first in, first out.” This means that you sell the first shares that you bought. So, you might have bought 100 shares that cost you $10 apiece a few years ago. A couple years later, you bought 100 more shares at $25 apiece. Now, though, shares are worth $15. You decide you want to sell 50 shares. With the FIFO method of figuring cost basis, you sell the first 50 shares you bought. That means you assume a $500 investment, and your return now, selling those 50 shares, is $750, or a gain of $250 that needs to be reported to the IRS. This method will theoretically give you the best chances of realizing long term gains because you are always selling your earliest purchases first. But since the earliest purchases also tend to have the lowest cost basis (due to the rising nature of most investments), it could also mean that you are on average realizing the most gains.
- Average cost: With this method, you average out what you spent with how many shares you have. You spent $1,000 in your first round of buying, and $2,500 in your second. So you divide the total amount spent ($3,500) by your total number of shares (200) for an average cost of $17.50. Using the average cost method, you multiply your “original” 50 shares by the $17.50 that they are considered to have cost under this method, which is $875. The result is that now it looks as though you are selling at a loss of $125. This method is usually not the most optimal from a tax standpoint, but it does make calculations simpler.
- Specific identification: This method allows the most control, as you get to pick which lots you want to sell. If you want to maximize your gains, you can choose to sell the lower-cost first. However, if you are looking to maximize your losses for tax purposes, you can specify those specific lots where the purchase price was higher than the current price. In our example, you could choose to sell 50 shares of the shares you bought at $25 each. That puts you at $1,250 for your cost basis, which means that your loss now is $500. As you can see, this method is the most involved, especially once you add in the complexity that selling long term gains (investments you purchased for more than one year) are taxed at a lower rate than short term gains.
Those are the more common cost basis options, but there are others. Some funds will allow you to specify that you want your shares sold highest cost first, or lowest cost first. You can also say that you want to choose a last in, first out method of cost basis calculation. Not every broker or fund manager offers a wide variety of options, though.
Check into the options offered by your broker, and make sure you understand the implications of each type of cost basis identification. Before you sell your shares, look for information on the impact that each type will have on your tax situation. As you can see from above, just deciding how to figure your cost basis can make a big difference in whether you realize capital gains or capital losses in the eyes of the IRS.