By Kaye A. Thomas
Current as of February 12, 2013
Some investors may prefer the separate lot method over the average basis method.
The tax law lets you choose between two different methods of maintaining the cost basis of your shares: the separate lot method and the average basis method. Each has its advantages.
Maintaining the basis for multiple lots of mutual fund shares using the separate lot method can be cumbersome, as explained in our page Using the Separate Lot Method. The average basis method doesn’t eliminate all the recordkeeping difficulties (see Using the Average Basis Method), but overall this method can be easier to use.
Selling high-cost shares
If you acquire mutual fund shares over a period of time, you’re likely to buy some at higher prices than others. In a subsequent sale of part of your holdings it may be advantageous to select the shares with the highest cost basis, permitting you to report a smaller gain or larger loss. This opportunity isn’t available when you use the average basis method: by definition, all shares to which the method applies have the same basis. For this reason, the separate lot method, though more complicated, may be more tax-efficient.
Selling newer shares
When selling shares at a loss, it can be advantageous to sell shares with a short-term holding period because these losses count first against short-term gains. When using the average basis method you have to sell your oldest shares first, and that could mean selling long-term shares when you’d rather sell short-term shares.
It appears that you can avoid this problem, however. The tax regulations permit you to change from the average basis method whenever you want. You can switch to the separate lot method, then use share identification to sell your short-term shares. Afterward you can elect to resume using the average basis method if you wish.
Averaging can work better
Although averaging is the less flexible method, there are circumstances where it can produce a better result.
Example: You’ve been using the separate lot method to track cost basis as you acquired shares over a period of time. You have long-term shares with a $10,000 loss and an equal number of short-term shares with no gain or loss. You’re planning to sell all these shares in a year when a short-term loss would be more valuable than a long-term loss.
If you sell the shares under the separate lot method, all your loss will be in the less valuable long-term category. If you elect the average basis method before selling all these shares, half the loss will be long-term and the other half will be short-term (because you own an equal number of shares in each category).
The old version of the regulations said averaging can’t be used where it appears that a purpose of using the method is to convert capital gains or losses from one category (short-term or long-term) to the other. This rule was eliminated when the regulations were revised in connection with the cost basis reporting rules.
In the past, most investors used the average basis method due to the complexity of the separate lot method. This issue has become less important now that brokers and mutual fund companies are required to maintain and report cost basis for covered shares. What’s more, many of these companies now make it easy to sell separate lots according to a standard procedure (such as selling the shares with highest basis first) that will often be more tax-efficient than the average basis method.
At the same time, you should be aware that basis records maintained by your broker or mutual fund company aren’t always accurate. It makes sense to consider consider using the separate lot method when it seems likely to produce a better tax result, but only if you don’t anticipate problems in dealing with discrepancies between figures reported by the company where you invest and the figures you’re required to report on your tax return.
Note that most mutual fund companies and some brokers have adopted the average basis method as their default method. To use the separate lot method at these companies you’ll have to notify them — and a separate notification may be required each time you start a different account or even make your first investment in a different mutual fund. See Electing a Cost Basis Method.