If you're thinking about selling stocks, mutual funds or other investments, you need to first familiarize yourself with the cost basis rules and their implications for your tax bill. Learning the rules may help you significantly reduce the amount of capital gains that will be subject to taxation as a result of the sale.
Why Cost Basis Matters
Cost (or tax) basis generally refers to the amount you paid for an investment, including any brokerage fees, loads and other costs. It's adjusted for developments, such as mergers, stock splits, dividends and capital gains distributions.
For example, your cost basis increases if you reinvest dividends and capital gains distributions to buy additional shares. Such distributions are treated as taxable income, so you might inadvertently pay taxes on them twice if you fail to include them in the cost basis.
When you sell an investment, your capital gain or loss equals the difference between the cost basis and the sale price. In other words, the higher your cost basis in the investment, the smaller your taxable gain. The cost basis for a particular investment depends on the method you apply when selling it.
Methods for Calculating Cost Basis
The method you select is especially important if you've been regularly adding shares to your investment, meaning you own shares with different prices and holding periods. The most common methods used to determine cost basis are:
First-in, first-out (FIFO). This is the default option for many brokerage firms (for investments that aren't mutual funds) if the investor doesn't instruct them to apply a different method. The FIFO method assumes that you're selling the oldest shares you own (that is, those that you bought first). Because your oldest shares tend to be the shares that you've purchased for the lowest cost, FIFO generally produces a larger gain—and, in turn, tax liability—than you'd shoulder under other methods.
Specific identification. This method is more likely to minimize the capital gains on your sale. "Specific identification" means you designate the particular shares to be sold. The method requires more work than others, but it gives you greater flexibility from a tax planning perspective. If you go this route, make sure you receive confirmation from your broker of your specification—you'll need this at tax time.
Average cost. Mutual fund investors have another option that's not available for individual stocks or other types of investments. Under this method, you calculate the average cost of all your shares in the mutual fund:
Average cost = Total investment (including reinvestments) / Number of shares
You then multiply that figure by the number of shares you're selling. This generally is the easiest method for investors who reinvest dividends and capital contributions or regularly purchase additional shares in the fund. However, if you choose this method, you must apply it for every future sale from the fund.
Additional methods may be available (depending on the type of investment). Examples include:
No method is universally preferable; each comes with pros and cons. The right choice turns on your circumstances and priorities. For example, if tax reduction is your main concern, the specific identification method may prove optimal.
Caveat about the Wash Sale Rule
If you plan to purchase the same type of investment around the time of your sale, you must pay close attention to the timing or risk becoming subject to the wash sale rule. This rule disallows a capital loss when you purchase the same or "substantially identical" security 30 days before or after a sale.
It applies to stocks, exchange-traded funds and mutual funds, as well as selling a security and buying an option on it within 30 days. The rule includes purchases made by your spouse or a corporation that you control, too. And it considers purchases from all your accounts. For instance, you'll trigger the wash sale rule if you sell stock at a loss from an investment account and then purchase shares in the same company within 30 days from a retirement account.
The wash sale rule also isn't limited by the calendar year. If you sell on December 31, you still must wait 31 days into the new year before purchasing the same stock to avoid triggering the rule and being barred from claiming a loss on your taxes.
If you do trigger the rule, you're allowed to add the amount of the loss to the cost basis of the replacement shares, and the holding period of the investment sold is added to the holding period of the replacements. The higher tax basis on the replacement shares will reduce the amount of gains when they're sold.
Proceed with Caution
Savvy investors take the cost basis into account before selling off investments. Contact your financial or tax advisor to determine the optimal method to determine your basis for your situation.
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