Cost basis methods

If you sell shares of a stock, bond, ETF, or mutual fund in a taxable account, you pay a capital-gains tax on the difference between the basis (what you paid, with adjustments) and the sales price (what you sold it for). These transactions are reported in IRS Form 1040 Schedule D: basis is reported in Column (e), "Cost or other basis"; sales price is reported in Column (d), Sales price.

You must choose an accounting method for each fund you hold in order to determine the basis. IRS Publication 550 describes the four allowed methods for mutual funds. The methods are of one of two types: cost basis methods and average basis methods. (You may not use average basis methods for individual stocks.) In a cost basis method, every share has its own basis, and the accounting method determines which share you sell. In an average basis method, the basis of a group of shares is averaged over all the shares.

For stocks and ETFs purchased in 2011 or later, and mutual funds purchased in 2012 or later, the brokerage or mutual fund company is required to do the accounting according to one of these methods, and report data to the IRS; for earlier purchases, the brokerage will not report to the IRS, but you still need to keep your own records in order to report the data on your own tax form.

The examples in this page show the different tax effects in the following sample situation:

• Ten years ago, you bought 100 shares at $30.
• Five years ago, you bought 100 shares at $40.
• Six months ago, you bought 100 shares at $50.
• Two months ago, you bought 100 shares at $60.
• Today, you want to sell 100 shares at $60.

FIFO (first in, first out)

In this method, the first shares purchased are assumed to be the shares sold. In the example above, you sell the shares bought ten years ago; since you bought them for $3,000, your basis is $3,000, and your capital gain is $3,000.

This is the default accounting method; the IRS assumes that you used it unless you have records to support another method. If you have not given your brokerage other instructions and you say "Sell 100 shares" without identifying which 100 shares, the shares will be FIFO. This method is the simplest, but it usually leads to the largest tax bills if you use it for stock funds, because shares tend to rise in value and the oldest shares will usually be the ones bought for the lowest price.

Specific share identification

In this method, you may choose which shares to sell. You must be able to adequately identify the shares sold. You may have a standing order such as "Sell highest-cost shares first" or "Sell lowest-cost shares first"; Vanguard, for example, allows you to specify HIFO (highest-in-first-out) for an account. You may also provide specific identification with every transaction. If you identify a specific transaction, the IRS says that you can do this if you specify the shares sold to the agent (the broker or mutual fund company) when you make the sale (up to the settlement date, which is three days after the sale date for most stocks), and receive written confirmation from the agent selling the shares. In the example above, you could choose to sell the 100 shares bought two months ago; your basis in those shares is $6,000, so you have a zero capital gain.

If you hold stock certificates (very rare for mutual funds, and no longer common even for individual stocks), then you specify which shares to sell by which certificate you give to the broker for the sale.

This method requires the most record-keeping (particularly if your brokerage doesn't make it easy, and Vanguard did not make it easy until the new IRS requirements came into effect), but it allows you to minimize your tax bills, and the tax savings can be very large. See Specific Identification of Shares for more information about the advantages, and details of how to use this method with Vanguard.

Average basis, single category

In this method, all of your shares in a fund have the same basis, which is the average cost (or other basis) of all shares at the time they were purchased (adjusted for previous sales followed by subsequent purchases). Shares are still sold in the order purchased. In the example above, you paid $18,000 for 400 shares, so your average basis is $45 a share; when you sell 100 shares at $60, your basis is $4500, your sales price is $6000, and the capital gain is $1,500. It is a long-term gain since you sold the shares you bought ten years ago.

Once you have averaged shares, they remain averaged for future transactions. In the example above, your basis is $45 in all 300 remaining shares; if you change to specific identification in the future, you cannot sell shares with a $30 or $60 basis.

For mutual fund shares bought before 2012, and as an option in the future, Vanguard provides the records for using this method. If you use another method, you need to ignore Vanguard's reported gains on the confirmations you receive, and you will need to update Vanguard's cost basis records for your old shares when Vanguard makes the records available in 2012.

Average basis, double category

This method was disallowed for sales beginning on April 1, 2011; any double-category account must be converted to a single-category account.

In this method, you have separate sub-accounts of short-term and long-term shares, and you may sell shares from either sub-account, but you need to specify which account you are using and receive confirmation of the choice, or it will be assumed that all sales are from long-term shares. Within each sub-account, your basis is the average cost of all shares in that category and you sell the oldest shares in the category. In the example above, you have 200 short-term shares with an average cost of $55, and 200 long-term shares with an average cost of $35. When you sell 100 shares at $60, you could choose to sell short-term shares for a capital gain of $500 (taxed at the higher short-term rate) or long-term shares for a capital gain of $2,500.

Given the record-keeping burden, it is rarely worth using this method; if you are going to keep the necessary records, you might as well use specific identification of shares for the greater tax benefit.

Choosing a method

Starting in 2011 (for stocks and ETFs) and 2012 (for mutual funds), you must tell your custodian (the brokerage or fund company which holds the assets) which accounting method to use. The brokerage can allow you to use a choice other than the standard choices, such as highest-in-first-out; if you use such a choice, you are effectively using specific identification, but giving a standing order to the brokerage, "Always sell the shares with the highest cost." (This option usually minimizes taxes, but you may need to override the decision to minimize taxes in some situations; for example, you might have a $2,000 short-term gain on the highest-cost shares and a $3,000 long-term gain on the lowest-cost shares.)

Vanguard's default choice is average basis for mutual funds and FIFO for stocks. If you owned mutual funds before Vanguard was required to keep track of the basis, your old shares will be assigned an average basis in Vanguard's records; you should be able to edit the basis yourself. (For old shares, your brokerage is not required to report the basis to the IRS, but Vanguard will do the calculations for you.)

Changing methods

In 2011, you were required to use the same method for each fund even if the fund is held in multiple accounts. Starting in 2012, you are allowed to use single-category average basis and other methods for different accounts even in the same fund. You may also change accounting methods at any time. Thus, if you made your first sale as FIFO, you may specifically identify another sale as long as you do not sell the shares already sold. If you change to another method from single-category averaging, all shares keep their average basis (i.e., they retain the basis computed prior to the change).

You may also choose to use different methods for different funds held in the same account; for example, you might use FIFO or average basis for a bond fund (for which the methods make little difference) and specific identification for a stock fund.

Cautions

There are some complications to the computation of basis and some restrictions on taking of losses. See the links below for more information, and do not treat this wiki page as tax advice.

See also

• Specific Identification of Shares

External links

• IRS Publication 550 Investment Income and Expenses
• IRS Cost Basis Reporting Overview and FAQs, contains updates for 2012 reporting methods.
• Capital Gains and Losses, IRS Schedule D (Form 1040): instructions, form
• Fairmark mutual fund tax guide
• Federal Register publication of 2011-2012 changes
• Cost Basis Method, forum discussion.
• Vanguard FAQ on cost basis
• VANGUARD ANSWERS YOUR COST BASIS QUESTIONS, comprehensive discussion by forum member Rebecca_Katz (Vanguard employee) on Vanguard's cost basis methodologies and processes. Contains detailed answers to forum member's questions.

 

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