Cost basis methods

If you sell shares of a mutual fund in a taxable account, you pay a capital-gains tax on the difference between the basis (what you paid) 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 564 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.) The two cost basis methods are FIFO and specific share identification; the two average basis methods are single category and double category.

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. The basis is the cost of those shares. In the example above, you sell the shares bought ten years ago; since you bought them for $3,000, your basis is $3000, 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. Effective in 2012, you must tell your broker which method you use, but you may do it by giving your broker a standing order such as, "Always sell with an average basis", or "Always sell the shares with the highest cost basis."

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. The basis is the cost of those shares. 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". 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 for 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 doesn't do this yet although IRS rules will require Vanguard to support it in 2012), 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.

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.

Average basis, double category
This method will be disallowed for sales beginning on April 1, 2011; any double-category account will 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.

Changing methods
Once you have used the single-category or double-category average basis method for a mutual fund, you must continue to use it for all sales of the same fund, unless you get IRS permission to change. In 2012, you will be allowed to use single-category average basis and other methods for different accounts, and you will be allowed to change to another method. 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).

However, you can change methods from FIFO or from specific identification; 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. You may also use different methods for different funds in the same account, such as using FIFO for a bond fund (for which the method doesn't matter much) 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.

Links

 * IRS Publication 564 Mutual Fund Distributions
 * Capital Gains and Losses, IRS Schedule D (Form 1040): instructions, form
 * Fairmark mutual fund tax guide
 * Federal Register publication of 2011-2012 changes