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Course 507
Calculating Your Cost Basis

Introduction

Leave it to the IRS to complicate things.

The agency 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. (Note that these issues only apply to securities you hold in your taxable account. You can buy and sell shares in a tax-sheltered account like an IRA or 401(k) without facing tax consequences until you begin withdrawing the money.)

Cost basis may seem pretty straightforward—and it is, if you buy a security only at one point in time. But what if you've been investing a little bit in a fund over a period of years? That's when things get tricky. Choose one method for cost basis over the others and you may be able to keep more for yourself and give less to Uncle Sam.

First In, First Out (FIFO)

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 you purchased the shares. While pretty straightforward, this procedure may lead 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.

What's the Difference?

Which method works best varies from situation to situation.

Let's take an example. Robert bought 25 shares of the no-load Raging Bull Fund at $9 apiece in 1998. He purchased another 50 shares at $10 apiece in 2000, and 25 shares at $11 each in 2002. In early 2003, he decided to sell 30 of his 100 shares at $12 apiece, for a total sale of $360. Assuming all his gains are long term, which method for calculating cost basis should he use, and what will his taxable gains be?

If Robert uses FIFO, he'd sell his oldest shares first. The calculation:

(25 x $9) + (5 x $10) = $275 cost basis

His taxable gains would be his total sale minus his cost basis, or:

$360 - $275 = $85

If Robert chooses the specific-share identification method, he'd sell his most expensive shares first.

(25 x $11) + (5 x $10) = $325 cost basis

His taxable gains would be:

$360 - $325 = $35

If Robert goes the single-category averaging route, he'd divide the total cost of shares by the total number of shares owned to get his average share price. He'd then multiple by number of shares sold for total cost basis.

(25 x $9) + (50 x $10) + (25 x $11)

x 30 = $300

100

His taxable gains would be:

$360 - $300 = $60

Robert can't use the double-category averaging method, because all his gains are long term.

Robert minimizes his taxable gains by using the specific-shares method: His taxable gains are just $35 versus $85 under FIFO and $60 using the single-category averaging method. With a little effort and a calculator, you can reduce Uncle Sam's take, too.

Quiz 507
There is only one correct answer to each question.

1 What is cost basis?
a. The amount you pay the IRS when you sell shares.
b. The price you paid for a security, including commissions and other expenses.
c. Your fund's annual costs.
2 To determine your profit or loss in a fund:
a. Subtract the cost basis from the current selling price.
b. Subtract the current selling price from the cost basis.
c. Add together the cost basis and the current selling price.
3 Which method for calculating cost basis is best?
a. FIFO.
b. Specific shares.
c. It depends on the situation.
4 In the single-category averaging method:
a. You sell the first shares you bought.
b. You divide the total cost you paid for your shares by the total number of shares you own and get an average cost basis for each share.
c. You ask the fund to sell shares you paid the most for but have held for at least one year.
5 The double-category averaging method for caculating cost basis is only applicable if:
a. You have both short- and long-term gains.
b. You made a lump-sum investment and haven't added to it since.
c. You want to sell your entire position in the fund.
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