Four Ways to Calculate Cost Basis in 2012

Investors who buy mutual funds this year will be subject to new IRS rules regulating how the cost basis - and subsequent taxable gains - of sold shares are reported and calculated.

Mutual fund shares acquired before 2012 are generally not covered by the new rules, which require brokers transacting mutual fund trades to report gains and losses to the IRS, as well as the investor. Previously, brokers were required to report gains only to investors, who in turn filed with the IRS.  

Investors can choose among four different methods for calculating the cost basis, or the price paid, for the mutual fund shares. “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,” according to a Morningstar Investor Workshop. “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.”

FIFO – First In, First Out

The First In, First Out - or FIFO - method is simple to use, according to the Vanguard Cost Basis Resource Center. The first shares acquired are the first ones to be sold. FIFO can be less tax-efficient than other methods of calculating cost basis as capital gains and losses are determined by the market.

Average Cost

The Average Cost method calculates the average cost per share of each share owned. Vanguard describes the Average Cost method as simple and requiring minimal bookkeeping, but as possibly less tax-efficient, depending on market events.

Specific Share Identification or SpecID

The Specific Identification or SpecID method allows investors to choose which share to sell. SpecID gives investors more control over the tax consequences of their investments and offers the potential for greater tax efficiency. Vanguard warns that the method calls for a hands-on investor who keeps detailed records.

Double-Category Averaging

In a Double-Category Averaging calculation, mutual fund shares are divided into two categories, short-term and long-term gains, which are taxed at different rates, according to Morningstar. Investors must give written instructions for selling a specific number of shares for each category.

Investors who regularly purchase a small number of mutual fund shares, a process known as cost-averaging, may find cost basis calculations particularly daunting. A financial professional can play a role in helping investors determine the most advantageous cost basis method. A Certified Public Accountant, or CPA, is specially trained and licensed to help investors develop tax planning strategies and file income taxes, according to the American Institute of CPAs or AICPA.

The role of a CPA includes gathering information, such as recent tax returns and brokerage statements, the AICPA said. Accountants also prepare tax projections and develop alternative strategies to meet income tax and financial planning goals. A CPA can be engaged to implement various recommendations, such as a preferred cost basis calculation.