Question on cost basis for mutual fund sale on noncovered shares

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  • #1337
    Dyons
    Participant

    Hi all:
    I am trying to make sense of something I read in a Fairmark article at: https://fairmark.com/investment-taxation/capital-gain/selling-mutual-fund-shares/changing-cost-basis-methods/

    The text about changing the cost basis of noncovered shares says: “”For noncovered shares….your’re on a one way street. ……Once you do this [[i.e., use the average basis method]] there’s no going back: the average basis method will continue to apply to all future sales of noncovered shares of this mutual fund from this account.” I cannot understand this assertion. It seems to apply the average basis method to the sale of all remaining noncovered shares, even noncovered shares which were acquired after a sale from this mutual fund, i.e., for shares which were not used in the averaging of any prior sale.

    Let me explain with an example: I have had a mutual fund since 1998 and have detailed statements recording the initial purchase, intermediate purchases as well as all dividends and cap gains reinvestment and ONE sale. At no time, until very recently when I decided to sell some shares to fund college costs, did I think about cost basis. What I’m saying is that I did not formally invoke/elect/choose a cost basis method until very recently. For that one sale in the past, the mutual fund provided the 1099-D with average cost, which I used that year in my tax returns.

    With this preamble, let me provide some more details (the precise dates don’t matter IMO) to help you understand my questions that follow:

    1998: First purchased shares in this mutual fund.
    1998-6/2000: All dividends and cap gains reinvested.
    6/2000: Sold some shares in a single sale. Having not formally selected a cost basis method, these were sold and reported using Average Cost.
    6/2000-July 2018: All dividends and cap gains reinvested.
    7/2018: Formally changed cost basis method (via the mutual fund’s web site) to Selected Lots/Shares.

    I understand that any shares purchased in the period 1998 though the first and only sale in 6/2000 must use average cost for calculating their basis when sold (because that was the fund’s default and I made no explicit choice and used that in my 2006 tax return).

    My questions below are about the cost basis of shares for the period 6/2000 (after this single sale) until 7/2018 (when I made a formal choice of the cost basis method).

    If I were now to sell some shares in this mutual fund and chose selected shares (which I seem to be able to do when attempting a “pretend” sale on the fund’s website and backing out before committing),
    (a) If I choose to sell specific shares purchased (through reinvestment) during the period 6/2000 through 12/31/2011 (i.e., these are all noncovered shares), can I use the cost basis of those specific shares using their actual purchase price/share?
    OR IS IT THE CASE THAT
    (b) Having sold a lot of shares in 6/2000 and not formally revoked the average cost method until 7/2018, do all the shares during this period (6/2000-12/3/2011) have their basis as average cost? This is what the earlier quoted seems to suggest

    Thanks for any help in clarifying my questions and understanding the rules.

    #1339
    Kaye Thomas
    Moderator

    To begin, there is some ambiguity as to whether your initial sale validly used the average basis method. At that time, there was no such thing as a mutual fund default method. Many mutual funds, as a convenience to their customers, provided average cost information at the time of the sale, but the default was separate basis, and according to the regulations, you had to attach a statement to your return affirmatively electing an average basis method if that is what you intended. Few people understood this, so most taxpayers who received average basis information from mutual funds reported their sales using average basis without attaching the statement required by the regulations. The IRS never enforced the requirement to attach a statement, so as a practical matter everyone who used average basis on a tax return was treated as having made a valid election. Given this state of affairs, there are pretty good arguments on both sides of the question whether you’re bound by the average basis method you used on that first sale.

    Assuming we are to treat the election as valid, the rules in effect at that time said the election shall apply to all shares held by the electing taxpayer on or after the first day of the first taxable year for which the election is made, and the election may not be revoked without the prior written permission of the IRS. That language seems to preclude you from using approach (a) in your question. There’s no apparent policy reason against permitting that approach, but the regulations are pretty clear in saying it is not permitted, except in the case where you request and obtain a private ruling from the IRS.

    You could, however, take the position that having failed to make an explicit election of average basis method, you aren’t bound by that method. You can’t take inconsistent positions as to the basis of the shares held at the time of that sale, so the practical way of dealing with those shares is to apply the average basis method to any shares that remained unsold as of that date, but then (because no election has been validly made) use separate basis for any shares acquired afterward. In other words, use your method (a), not because it is a permitted approach, but because it is a reasonable, good faith method of dealing with the fact that you failed to make an effective election at the time of your earlier sale.

    Audit activity with regard to basis reporting in sales of securities has always been pretty close to zero, which is the reason for the broker reporting requirements. You should be able to sleep well after using either of these approaches. Understand, though, that in using (a), you aren’t doing something that is permitted by the regulations, but dealing in a reasonable way with an error made on a previous sale, where you used average basis without having met the formal requirements for electing that method.

    #1344
    Dyons
    Participant

    Thanks, Kaye, for your thoughtful and detailed response.

    At least Fidelity seems to agree with interpretation (a), if their trades web site interface is any gauge. In my case, when attempting a “trial” trade, I notice that Fidelity has populated the unsold shares from the 1998-6/2000 period with the average cost calculated for the sale on 6/2000. For both uncovered and covered shares after 6/2000, Fidelity assigns the actual NAV for the date of purchase of additional shares. Thus, at least Fidelity seems to think that noncovered share purchased after my one and only sale should not use average cost.

    Thus, I feel quite comfortable about interpretation (a), especially after your detailed explanation and Fidelity’s implicit confirmation.

    Many thanks for your help.

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