By Kaye A. Thomas
Current as of February 13, 2013
You can stop using the average basis method prospectively, and in some cases you can get out of that method retroactively.
Your choice to use the separate lot method or the average basis method for mutual fund shares in one year doesn’t necessarily lock you into using that method for all future years. Generally you can change from the separate lot method to the average basis method any time you want. For covered shares (generally shares bought after 2011) you can also change back to the separate lot method, although in some cases this change will affect only the shares you acquire after making the switch.
For noncovered shares (generally shares acquired before 2012) you’re on a one-way street. You’re considered to be using the separate lot method until such time as you switch to averaging. (The default method used by your broker or mutual fund company does not apply to these shares.) You can use the average basis method beginning with any year you choose, even if you used the separate lot method for sales from this account in earlier years. Once you do this, 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.
Strictly speaking, there’s nothing in the regulations to prevent you from terminating your use of the average basis method for these shares prospectively (see below). Yet any shares you buy in the future will be covered shares, so prospective termination of the average basis method for noncovered shares has no effect except in unusual circumstances, such as receiving a gift or inheritance of noncovered shares.
Changing prospectively for covered shares
The tax regulations now contain this helpful rule: “A taxpayer may change basis determination methods from the average basis method to another method prospectively at any time.” You do this by notifying the broker or mutual fund company “in writing by any reasonable means,” which would include completing an online form if the company provides one for this purpose.
A prospective change from the average basis method doesn’t restore the original basis of lots you own at the time of the change. These lots will continue to have the same averaged basis they had at the time you made the change. Any lots you acquire in the future won’t be averaged with these lots, however.
Example: Using the average basis method, you bought 100 shares at $10 and another 100 shares at $20. Then you changed from the average basis method prospectively and subsequently bought another 100 shares at $30. The result: you hold two lots with basis of $15 per share and another with basis of $30 per share.
Changing from the average basis method lets you acquire additional shares with a cost basis that differs from your existing shares. It also permits you to use share identification, so you can sell newer shares before older ones in situations where that would produce a tax benefit. Share identification isn’t permitted while using the average basis method.
Changing retroactively for covered shares
Subject to limitations, it may be possible to undo the average basis method retroactively, restoring lots to their original cost basis. The tax regulations provide this result when you revoke an election to use the average basis method. In Notice 2011-56, the IRS provided similar relief for situations where the average basis method was applied because it’s the default method of the broker or mutual fund company rather than because the investor elected that method.
Example: In the example above, if you revoked an averaging election instead of changing from it prospectively, the first two lots would revert back to their original bases of $10 and $20.
Limitations. You aren’t allowed to change your method retroactively after you’ve sold any shares while the average basis method was in effect. In this situation you can change to the separate lot method prospectively, but it won’t be possible to restore the original cost basis of lots you held while using the average basis method.
In addition, you can’t make this retroactive change after the time limit set by your broker or mutual fund company expires. They’re required to allow at least a year, but permitted to allow a longer period, and many mutual fund companies have indicated they’ll be lenient, perhaps even permitting these changes for an indefinite period. Be aware, though, that the first sale of shares terminates your ability to make this retroactive change, even if it occurs within the first year.
If you’re using the average basis method due to having elected it (by notifying the broker or mutual fund company), the minimum one-year period is measured from the date you made the election. If you’re using it automatically due to the default method chosen by the company, the one-year period runs from the date they notified you of their default method.
Working with the rules
If the average basis method is in effect, either because of your election or because of the company’s default method, you may lose the opportunity to sell shares using the original cost basis, either because you sold shares from the account or simply through the passage of time. If you want to preserve your ability to fine-tune the tax consequences of sales from the account, you should not elect the average basis method and, if this is the company’s default method, you should notify the company that you want to use the separate lot method. If you’ve already acquired multiple lots before notifying the company, tell them you want to undo the averaging retroactively as provided in IRS Notice 2011-56.