Methods for Calculating Cost Basis

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Methods for Calculating Cost Basis

The IRS has pages and pages of tax laws and more forms than you can shake a stick at. It even has four ways of calculating something as simple as cost basis, or the price you paid for a security, including commissions and other expenses. Cost basis is important because you determine your profit (or loss) when you sell shares by subtracting your cost basis from the shares’ current selling price. That difference is the amount the government taxes.

First in, first out

The most basic method for figuring cost basis is FIFO, or first in, first out. This approach assumes that, as you sell shares of a stock or mutual fund, you do so in the order in which the shares were purchased. While pretty straightforward, this procedure often leads to substantial taxable gains because the longer you hold shares in a rising market, the more they’re worth. No wonder the IRS assumes you are using this method unless you indicate otherwise.

Specific share identification

Specific-share identification, the second way to calculate cost basis, is for meticulous investors only. If you’ve kept careful records of when you bought stock or fund shares and how much you paid for them, you can ask a mutual fund or broker to sell specific shares. Normally, these shares would be the ones you paid the most for, since they would generate the smallest taxable gains.

But there’s a catch. Gains are taxed at different rates depending on how long you’ve held the shares. Profits made on shares you’ve held for a year or less are taxed at rates significantly higher than those levied on shares held longer than a year. So consider the matter carefully before deciding to hawk expensive newer shares.

Single-category averaging

Another method for mutual fund investors is single-category averaging. Divide the total cost you paid for your shares by the total number of shares you own and voila, you have your average-cost basis for each share. Single-category averaging is quite popular with investors because it doesn’t take much energy to calculate. But once you begin using it to compute cost basis, the IRS prohibits switching to another method without prior approval.

Double-category averaging

Finally, there’s double-category averaging. Mutual fund shares are divided into short-term and long-term gains and are then averaged for cost basis. Of course, different tax rates apply to each category, and you must tell your mutual fund in writing how many shares from each category you want to sell. Definitely not a process for the faint of heart.