Overview of Cost Basis Methods

Investors often make multiple purchases of the same stock or mutual fund. Each group of shares bought at a different time or price from your other shares is a distinct lot, with its own cost basis and holding period. When you sell a portion of your holdings, your cost basis method can affect the amount of gain or loss, and also the character of gain or loss (short-term or long-term).

Example: You bought 100 shares of XYZ at $30 and another 100 shares a month later at $40. Now you’re selling 100 shares at $37

Three different outcomes are possible:

• Using the separate lot method without identifying the shares you’re selling, you would sell the oldest shares (bought at $30) and report gain of $700.
• Using the separate lot method and identifying the shares sold as coming from the second lot (bought at $40), you would report a loss of $300.
• Using the average basis method you would sell shares from the older lot but their basis would be $35, the average for all shares in the account, so you would report gain of $200.

The following chart shows how cost basis methods work conceptually:

 

When you use the average basis method, each share is treated as having a cost basis equal to the average basis for all identical shares in the account. This method is available for mutual fund shares and can also be used for stocks of individual companies if held in a dividend reinvestment plan. When you use the average basis method, you’re always treated as selling your oldest shares first. This order of disposition is sometimes called first-in, first out, or FIFO.

If you aren’t using the average basis method, each lot has its own basis. When using the separate lot method, the default order of sale is first-in, first-out (oldest shares first), but in this case you’re allowed to override the default by identifying the shares you’re selling. There are two ways to do this:

• At the time of the sale you can specify what lots you’re selling.
• Alternatively, you can place a standing order with the company where you invest to automatically select the shares you’re selling according to some rule other than FIFO. For example, you might automatically select the shares with the highest basis first, a method sometimes called HIFO.

Understanding the chart

The first division is between the separate lot method and the average basis method. At this level we’re talking about different ways to maintain basis for your lots of shares.

At the next level we’re talking about different ways to determine the order of disposition of those lots. When you’re using the average basis method you don’t have a choice: FIFO is automatic. When using the separate lot method, FIFO applies unless you identify the shares you’re selling.

The last level is for different ways to identify shares. You can identify the specfic lots you’re selling in connection with a particular sale, or you can place a standing order with your broker or mutual fund company to sell shares according to a methodology you prefer.