If you are planning to sell shares of stock, mutual funds or other investments, familiarize yourself with the cost basis rules before you call your broker. And be sure you understand the different accounting methods available for determining which shares you sell. The method you choose can have a big impact on your tax bill.

Computing Basis

When you sell an investment, the gain (or loss) is equal to the sale price less your adjusted cost basis. Your adjusted basis is the amount you paid for the investment, including commissions, and adjusted to reflect certain events, such as corporate actions (for example, stock splits or mergers) and wash sales.

The wash sale rule prohibits you from deducting a loss on a sale of securities if you acquire substantially identical securities within 30 days before or after the sale. Instead, the disallowed loss is added to your basis in the new shares, essentially placing you in the same position as if you had never sold the stock.

Suppose you own 100 shares of stock that you bought for $100. You sell the stock on Dec. 31 of Year 1 for $80 and then buy the stock back for $80 on Jan. 2 of Year 2. The wash sale rule prohibits you from recognizing the $20 loss in Year 1. Instead, you must add that amount to your $80 basis in the new shares, bringing you back to your original basis of $100.

Tracking your basis requires detailed recordkeeping. Investors often fail to include automatic reinvestments of mutual fund distributions in their basis calculations, which can be a costly mistake. Be sure to retain brokerage account and mutual fund statements and confirmations. If you are unable to adequately document your basis, the IRS will assume that it is zero.

New Requirements for Providers

IRS regulations now require financial providers such as brokers and mutual fund companies to track basis, holding period, and sales proceeds for “covered securities” and to report this information to the investor and the IRS on Form 1099-B.

These rules relieve some of the pressure on investors to calculate basis.  But you’re not completely off the hook since this rule applies only to securities acquired after the relevant effective dates, so you remain responsible for reporting basis for older securities. (See the sidebar “New reporting rules: Which securities are covered?”) Also consider that even if a financial provider tracks your basis, you may want to choose the accounting method to help ensure you obtain the tax treatment that will best achieve your goals.

Methods

If you own multiple lots of a security, acquired at different times for different prices, and you sell a portion of your holdings, your choice of accounting method can have significant tax implications. Generally, the IRS allows investors to use these three methods:

First-in, first-out (FIFO)

The IRS default method, FIFO, assumes that the first shares purchased are the first shares sold. It has the advantage of simplicity. But if share values rise over time, FIFO increases your tax bill because older shares have a lower basis.

Specific identification

Under this method, you specify which shares are sold. It complicates record-keeping, but it gives you the flexibility to minimize your taxes. Suppose you purchased shares of a particular security as follows:

  • Five years ago, you purchased 1,000 shares at $50 ($50,000).
  • Three years ago, you purchased 1,000 shares at $75 ($75,000).
  • One year ago, you purchased 1,000 shares at $100 each ($100,000).

Now, say you plan to sell 1,000 shares at $110 ($110,000). FIFO assumes that you’re selling the block of shares you purchased five years ago, for a capital gain of $60,000 ($110,000 − $50,000). But by using the specific identification method, you can sell the block you purchased one year ago, for a capital gain of only $10,000 ($110,000 − $100,000).

For your convenience, a financial provider may offer various standing orders to choose from, such as last-in, first-out (LIFO) or highest-cost, first-out. Still, you should review each potential sale to avoid unwanted tax consequences. You may prefer to generate higher gains to offset capital losses during the year, for example.

Also, while selling the highest-cost shares tends to minimize gains, if you acquired the shares within the last year, those gains will be short-term gains taxed at your higher ordinary-income rate. To determine the optimal strategy, you must weigh the impact of smaller gains taxed at a higher rate against larger gains taxed at a lower rate.

Some providers offer a plan under which they select shares that minimize your tax liability, taking into account cost bases and holding periods.

Average cost

For mutual funds only, you can use average cost as the basis of all shares. In the above example, the average cost is $75. Presuming you purchased mutual funds and used the average cost method, the sale would generate a capital gain of $35,000 ($110,000 − $75,000).

This method generates less tax than FIFO but more than the specific-identification method. It also offers simplicity and tends to distribute your tax liability evenly over time.

But beware, once you’ve sold shares using the average cost method, you can change your method only for later-acquired shares. The basis of existing shares is locked in.

Act Before You Sell                                   

Whichever method you choose, it is important to communicate it to your financial provider before you sell.

Absent final instructions from the IRS, the default for most providers is average cost for mutual funds and FIFO for everything else.