Calculate the Cost Before You Sell

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
September 24, 2007

Planning to sell an investment that's appreciated in value? Being familiar with the tax rules may help you pay less in taxes and keep more of your gain.

First, let's look at how capital gains tax works. Changes to the law back in 2003 made an already great strategy—holding investments for the long term—a better deal than ever. To recap, realized gains on stocks, bonds and mutual funds held over one year are taxed at the long-term capital gains rate of 15%.¹ Short-term gains (on investments held one year or less) are still subject to ordinary income tax, which ranges up to 35%.

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, but calculating your cost basis can be more complex than you might think—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 broker reports the proceeds to the IRS on Form 1099-B. But your broker doesn't report your cost basis—that's up to you.

So, be sure to save the confirmations and statements that show what you paid for an investment and when you purchased it. For mutual funds, that includes statements showing automatically reinvested shares.

Adjusted cost basis
Your original purchase price may be adjusted up or down for any number of reasons (for more, see IRS Publication 550: Investment Income and Expenses). When you buy stocks or bonds, for example, you typically add any commissions and fees to what you paid per share to calculate your initial cost basis. After that, your per-share cost basis may be affected by stock splits, spin-offs and so on.

A common mistake investors make is failing to adjust their mutual fund cost basis for the automatic reinvestment of taxable distributions. Think of it this way: 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, called 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 (if you're interested in reading up on the bond reporting rules, check out IRS Pub 550 referenced above). Be aware there are some tricky calculations here. If nothing else, be sure to give your tax preparer the documents from your bond transactions and let him or her figure it out.

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), choosing which shares to sell is where you can potentially increase your after-tax profit.

Usually, you want to minimize taxes by recognizing the smallest gain (or largest loss) possible on your income tax return. Occasionally, however, 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

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 gave different instructions to your broker.

FIFO seldom provides the optimal result, and then only by accident. 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, you can have your broker add a memo line to your confirmation statement, per your instructions. For example, if you're selling the 100 shares you bought on March 31, 2003, ask your broker to write on your confirmation that the transaction is a sale "vs. purchase 3/31/03." For online trades, you should immediately follow up with a phone call to specify your instructions.

Mutual funds
For partial sales of an existing mutual fund position, you have four choices:

FIFO. As with individual stocks and bonds, the IRS presumes you sold 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 up the cost basis of your entire position and divide 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 sell 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, it generally gives a better result over time 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 provides a bit more flexibility than the single category method because you can specify which bucket your shares were sold 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 professional before entering into any transaction that may have significant tax consequences.

1. A special 5% long-term capital gains and qualified dividend tax rate applies to taxpayers below the 25% bracket, with that rate going to zero after 2007. Tax rates on long-term capital gains and qualified dividends are scheduled to revert to pre-2003 law after 2010.

Important Disclosures

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.

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