When you sell stock or mutual fund shares, your taxable gain or
deductible loss is the difference between the selling price and
your cost basis (generally what you paid for the shares).
When you sell stock or mutual fund shares, your taxable gain or deductible loss is the difference between the selling price and your cost basis (generally what you paid for the shares). But did you know that there are three different ways to calculate your cost basis and the method you choose could have a big impact on the taxes you pay?
The specific identification method allows you to specify exactly which shares you are selling. This method gives you greatest control over the size of your gain or loss, but has strict requirements. You must specify which shares you want your broker or mutual fund company to sell, and you generally must receive a written confirmation that those were the shares actually sold.
The FIFO or “first in, first out” method assumes that the shares you are selling are the ones you bought first. This is the calculation the IRS will use unless you choose otherwise. If your fund has risen steadily in value, this method results in the highest gain and greatest tax.
The average cost method simply divides the total cost of shares you’ve purchased by the total number of shares you own to determine the average share cost. This method generally produces lower taxable gains than using FIFO, but higher gains than specific identification. A refinement of the average cost method allows you to group shares into long-term or short-term holdings and calculate the average cost for each group. Note: You can use this method for sales of mutual fund shares, but not for individual stocks.
Once you have chosen a method for a particular mutual fund, you generally can’t switch to another method. All methods require good record-keeping, especially if you have reinvested dividends. And remember, if you are selling your entire holdings of a particular fund or stock, the method is irrelevant.
Minimizing the tax bite on investments requires planning. For assistance, please contact us.
Mary Hubbell is a partner with the accounting and business consulting firm of Bianchi, Lorincz & Co. in downtown Hollister and in Morgan Hill.