Tax Question of the Week: When I Sell an Investment, How Does My “Basis” Affect My Tax Bill?February 19, 2014
Make sure you understand the different accounting methods available for determining which shares you sell.
If you’re selling shares of stock, mutual funds or other investments, familiarize yourself with the cost basis rules before you call your broker. It is also important to 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.
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, adjusted to reflect certain events, such as corporate actions (for example, stock splits or mergers).
Using this method requires detailed record-keeping. It is common for investors to fail to include automatic re-investments 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’re unable to adequately document your basis, the IRS will assume that it’s zero.
New reporting rules
IRS regulations that are currently being phased in (see below) 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.
|Type of Security||Effective for shares acquired on or after|
|Stocks and certain ETFs*||Jan 1, 2011|
|Mutual Funds, all ETFs and DRIPs**||Jan 1, 2012|
|Bonds, options and all other securities||Jan 1, 2014|
* Exchange traded funds
** Dividend reinvestment plan
Although these rules relieve some of the pressure on investors to calculate basis, they aren’t a sure fire method for a few reasons. First, the regulations apply only to securities acquired after the relevant effective dates, so you remain responsible for reporting basis for older securities. Second, 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.
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 has significant tax implications. Below are the top three most popular 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). Using specific identification, on the other hand, 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.
It is important to note that 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.
Whichever method you choose, it’s important to communicate it to your financial provider before you sell. For many, the default is average cost calculation for mutual funds and FIFO for everything else. For more information on how the sale of investments affects your tax bill please contact any member of our Tax Services Team at firstname.lastname@example.org or call 401-274-2001.