It’s my annual “Taxes from A to Z” series! Next up:
When you buy a capital asset, the price that you pay for that asset is considered your basis. You use that price to figure any gain or loss at sale. So, let’s say that you buy a share of stock for $100 and sell it for $125, your gain, for tax purposes is $25. That’s Basis 101.
But what happens when you buy more than one share of stock? Or shares in a mutual fund?
If you sell them at the same time, it’s still pretty easy to figure. Let’s say you buy a share of stock at $100 and another share of the the same stock later at $110 and you sell both at the same time for $125 each, or $250. Your gain is now $40 or $250 – ($100 + $110). Got it?
But what if you buy both of those shares and only sell one? What’s your gain? Is it $25 ($125 – $100) or is it $15 ($125 – $110)? And what’s your holding period (meaning how long you held the share)?
That’s where things get tricky.
If you can clearly identify which share of stock (or bond) you sold, your basis is the cost of that particular share and the holding period is the holding period of that particular share. So if you can prove that you told your broker to sell the second share that you acquired, your gain is $15 ($125 – $110) and your holding period is long or short term as determined by how long you owned that particular share.
But if you cannot clearly identify the share of stock (or bond) you sell, your basis is the cost of the share you acquired first – same for holding period. This is sometimes referred to as FIFO, or first-in first-out.
So, in our example, your gain from the sale of one share is $25 ($125 – $100).
Those are your choices: specific share identification or FIFO. You cannot use any other method, including calculating the average price per share, to figure gain or loss.
There is one exception to this rule and that applies to mutual funds. With mutual funds, you can choose to use either the actual cost basis (using the specific share identification or FIFO) or an average basis to figure your gain or loss. You can only use the average basis method if the shares are identical to each other, you acquired them at different times and different prices or you acquired the shares after 2011 in connection with a dividend reinvestment plan (DRP) and you left them in an account with a custodian or agent.
Average basis is figured exactly as it sounds: by averaging the basis of all shares of identical stock in an account. However, because of the way averaging works, you can’t mix and match: you can figure your gain or loss using a cost basis only if you did not previously use an average basis.
So how do you prove which method you want to use? Easy: keep great records. When you go to sell your assets, give clear direction to your broker or other agent which shares are to be sold and get confirmation in writing. Remember: for tax purposes, it’s your burden to prove what you intended so don’t be sloppy when it comes to documentation.
