Adjusting your cost basis.
There are a variety of reasons you may want to adjust your original purchase price. When you buy stocks, for example, you typically calculate your initial cost basis by adding commissions and fees to your per-share purchase price. You can also make adjustments to account for events that affect the per-share price of a stock, such as mergers, stock splits, and spinoffs.
Your adjusted cost basis should also reflect reinvested dividends or distributions from mutual funds and exchange-traded funds (ETFs). Why? The IRS treats reinvested dividends as if the money had been distributed directly to you, meaning distributions in a taxable account will be reported on a Form 1099-DIV and taxed as regular dividend income. Adjusting your cost basis ensures you won’t also pay capital gains taxes on those funds.
Know your accounting method.
Another complication arises if you’ve purchased the same security on multiple occasions at a variety of prices.
For example, say you buy 100 shares of a stock for $50 each. A year later, you buy 100 more at $60 each. By the following year, the stock is trading at $80 and you sell 50 shares. Your capital gain will differ depending on which shares—those purchased for $50 or those purchased for $60—you sell.
Let’s look at two common accounting options for such cases.
- First in, first out (FIFO): This is the IRS’s default accounting method. For partial sales, the IRS presumes you’re selling the oldest shares first, which can lead to a larger capital gain if the oldest shares have appreciated more than those acquired later. In the example above, that would mean selling your $50 shares first, resulting in a capital gain of $30 per share, or $1,500 in total.
- Specific identification: This method allows you to identify which shares you’re selling at the time of the sale. It is more flexible than FIFO and gives you the opportunity to optimize results. For our hypothetical portfolio, you could choose to sell the $60 shares first, resulting in a capital gain of $20 per share, or $1,000 in total.
There are other accounting methods you may use as well. It may be a good idea to discuss your options with a tax professional before selling any investment.
Reporting and tracking cost basis.
Reporting your cost basis.
Your brokerage firm lists the proceeds of sales in your taxable account on Form 1099-B. It may also report your adjusted cost basis, but this will depend on when you bought the asset. Policy reforms introduced after the financial crisis require banks and brokerages to report adjusted cost basis for:
Whether your cost basis is reported to the IRS or not, you are ultimately responsible for the information on your tax return, so be sure to save your original purchase and sale documentation. For mutual funds, that includes statements showing automatic reinvestments.
Make sure your financial institution is using the accounting method of your choice. If not, you may want to adjust it for future sales.
Using cost basis reporting rules to your advantage.
Usually, you want to minimize taxes by recognizing the smallest net gain (or largest loss) possible on your tax return. However, on occasion you might want to do the opposite. For example, you may decide to recognize a larger gain if you can offset it with a current loss or capital-loss carryovers from previous tax years.
If you’re tax-smart about calculating and reporting the cost basis of your investments, you may be able to hold on to more of your return. Be sure to check with your tax advisor before entering into any transaction that may have significant tax consequences.
Tracking your cost basis.
You can check the cost basis of your Schwab portfolio on Schwab.com. Under the Accounts tab, click on Positions and then navigate to the Unrealized Gain/Loss tab.
Which method is best for you?
Choosing a method.
The best accounting method to choose is going to depend on you. If you have modest holdings and don’t want to keep track of when you bought and sold shares, using the average cost method with fund sales and the FIFO method with the sale of individual shares is probably fine.
But if you’re a tax-sensitive investor, specific identification can save you lots of tax money—especially if you use other tax-wise strategies, such as giving appreciated shares (rather than cash) to charity. You get credit for a charitable donation for the full market value of donated long-term shares, subject to certain income limitations, but because the charity is tax-exempt, no one pays the capital gains taxes.
What you can do now:
- Find out which cost basis method is your current default. If you’ve never investigated, chances are you’re defaulted into FIFO for stocks and average cost, and single category for mutual funds.
- Adjust your defaults if they’re not what you’d like them to be, and pay attention to which method you’re using the next time you sell.
- If you’re a Schwab client, you have access to a cost basis method called the Tax Lot Optimizer™. This method automatically looks for losses (short term, then long term) before realizing gains (long term, then short term).
- Before entering into any significant transaction, consult your tax professional on which method will work best for you.
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Clients of independent investment advisors: You may also contact your advisor or call Schwab Alliance at 800-515-2157.
Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager. Schwab does not provide legal or tax advice.
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