Calculating Your Cost Basis
- It's important to consider the tax implications before selling investments that have appreciated in value.
- Find out how to calculate, report and adjust your cost basis.
- We review the accounting methods you can use for individual stocks, individual bonds and mutual funds.
If you plan to sell an investment that's appreciated in value, familiarizing yourself with the tax rules may help you pay less in taxes and keep more of your gain.
First, let's look at how the capital gains tax works. Realized gains on stocks, bonds and mutual funds held over one year are taxed at a maximum long-term capital gains rate of 20%.1 Short-term gains (on investments held one year or less) are subject to ordinary income tax.
Whether short-term or long-term, the gain on your investment is the sale price minus your cost basis, or what you paid. It sounds simple enough, but in practice, calculating your cost basis can be complex —and if you calculate it incorrectly, you may overstate your gain and pay more tax than necessary. The accounting method you use to report your cost basis can have a big impact on your tax bill, as well.
Reporting your cost basis
When you sell a stock, bond or mutual fund in your taxable account—as opposed to a 401(k) or IRA—your brokerage firm reports the proceeds to the IRS on Form 1099-B. Since 2011, financial institutions have been required to report adjusted cost basis information to the IRS.
Cost basis reporting rules
Financial institutions are required to report the adjusted cost basis of sold securities to the IRS, including:
- Equities acquired on or after January 1, 2011.
- Mutual funds, ETFs and dividend reinvestment plans acquired on or after January 1, 2012.
- Other specified securities, including most fixed income securities and options acquired on or after January 1, 2014.
Keep in mind that the reporting rules only apply to the sale of securities purchased on or after the effective dates above. Whether cost basis is reported to the IRS or not, you are ultimately responsible for the information on your tax return. So, it’s a good idea to save your original purchase and sale documentation, including records of any automatic reinvestments, to make sure it matches the information financial institutions will report to the IRS. For mutual funds, that includes statements showing automatically reinvested shares.
You should also make sure your financial institution is using the accounting method of your choice. Even though FIFO (first in, first out) is the IRS default method for both individual securities and mutual funds, most institutions (including Schwab) will report individual securities using the FIFO default method and report mutual funds using the average cost single-category method.
Adjusted cost basis
Your original purchase price may be adjusted up or down for any number of reasons.
When you buy stocks, for example, you typically calculate your initial cost basis by adding commissions and fees to your per-share purchase price. An adjusted cost basis is necessary when events such as mergers, stock splits and spin-offs affect the per-share price of the stock. For more information on how to calculate your adjusted cost basis, refer to Chapter 4 of theIRS Publication 550: Investment Income and Expenses.
A common mistake some investors make is failing to adjust their mutual fund cost basis for the automatic reinvestment of taxable distributions. When you opt for automatic reinvestment, it's as if the fund is sending you the money and you're sending it back to purchase more shares. If the reinvestment took place in a taxable account, then you've already paid tax on that distribution. The last thing you want to do is pay tax twice by forgetting to add the reinvested distribution to your total cost basis.
Bond discounts and premiums
Special reporting rules govern the adjustment of cost basis on individual bonds purchased at a market premium or at a discount (either at the market or with original issue discount, known as OID). The rules are fairly complex and affect the reporting of current income, the ongoing adjustment of cost basis, and the treatment of gain or loss on sale.
Many of these rules are elective, but some are mandatory. You can review the bond reporting rules in the IRS Publication 550: Investment Income and Expenses, but be aware that some of the calculations are tricky. Most brokers, including Schwab, will amortize bond premiums automatically, but unless you’re familiar with the rules and enjoy working with numbers, we recommend letting your tax preparer determine the appropriate way to report your bonds' cost basis for you.
Use the reporting rules to your advantage
As you purchase investments over time, you'll likely end up with positions in individual securities and mutual funds consisting of different tax lots—shares purchased on different dates at different prices. If you later enter into a partial sale (you sell some shares and keep some shares of a particular investment), you can potentially increase your after-tax profit by choosing carefully which shares to sell.
Usually, you want to minimize taxes by recognizing the smallest net gain (or largest loss) possible on your income tax return. However, on occasion you might want to do the opposite. For example, you may decide to recognize a larger gain to offset a current loss and/or capital-loss carryovers from previous tax years.
In either case, you'll need to follow one of the basic, IRS-approved accounting methods for reporting recognized gain or loss in your taxable accounts.
Individual stocks and bonds
You have two choices when it comes to partial sales of individual stock and bond positions:
- FIFO. "First in, first out" is the IRS's default accounting method. For a partial sale of a particular stock or bond, the IRS presumes you sold your oldest shares first—unless you instructed your broker otherwise.
FIFO seldom provides the optimal result, and then only by chance. If the value of the shares you've held longest has declined since you bought them, FIFO will result in a capital loss. But if the price of your oldest shares has increased steadily since purchase, FIFO generally results in the biggest taxable gain.
- Specific identification. Specific ID offers more flexibility than FIFO, giving you the opportunity to optimize results. However, it requires some up-front planning. You must identify the specific shares you're selling at the time of sale and have your broker confirm that identification in writing within a reasonable period of time contemporaneous with the sale.
Typically, a memo on your confirmation statement will suffice. For example, if you're selling the 100 shares you bought on January 6, 2012, ask your broker to write on your confirmation that the transaction is a sale "vs. purchase 01/06/2012." For online trades, unless you have the ability to specifically identify the tax lot sold when you enter the trade (as Schwab clients do), you should immediately follow up with a phone call to make this request.
For partial sales of an existing mutual fund position, you have four choices:
- FIFO. As with individual stocks and bonds, the IRS presumes you redeemed your oldest shares first unless you instructed your broker or fund company otherwise.
- Specific identification. Again, specific ID provides the most flexibility and, generally, the most advantageous result.
- Average cost single category. Prior to your first partial sale, you total the cost basis of your entire position and divide it by the number of shares you own to determine your average cost per share. You would use this average per-share cost for all future sales as long as you hold the position, adjusted for any subsequent purchases. To determine whether short-term or long-term capital gains taxes apply, the IRS presumes you redeem your oldest shares first.
Once you start using the average cost method for a particular fund, you can't switch to another method without permission from the IRS. Although the average cost method gives you far less flexibility than specific ID, over time it generally produces better results than the default FIFO method. Conveniently, most brokers and mutual fund companies will keep an ongoing calculation of average cost basis for you, including automatically reinvested shares—check with the company for specifics.
- Average cost double category. Rarely used due to its complexity, this method allows you to calculate average cost in two capital gains buckets: short-term average cost and long-term average cost. The double category method is slightly more flexible than the single category method because you can specify which bucket your shares were redeemed from.
The bottom line
Remember, it's not what you make but what you keep that counts. 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.
1. Long-term capital gains and qualified dividends are currently taxed at a rate of 0% for income in the 15% federal marginal tax bracket or lower, 15% for brackets above that level up to the top bracket, and 20% for income that falls in the highest bracket.
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The information provided is for general informational purposes only. Nothing in this article should be considered as an individualized recommendation or personalized investment or tax advice. The investment and tax strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment or tax strategy for his or her own particular situation before making any decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.