Understanding Cost Basis for Your Investments

If you've ever received a Form 1099-B and tried to complete your own income tax return, you've wrestled with the issue of reporting the basis for an investment asset. Without knowing your basis—or the purchase price of the asset—you'll pay taxes on the entire sale price of the asset unnecessarily. Therefore, it's important to track your cost basis to know if you made a profit or loss on an asset and only pay the taxes you owe. There are several methods to choose from that we'll examine below.

Cost basis includes your investment's purchase price as well as reinvested dividends, fees, trading costs and one-time mutual fund commissions, also called load charges. Cost basis can also be adjusted when corporate events occur, such as stock splits, bankruptcies and mergers. For example, if a company has a stock split by turning one share into two, then your cost basis is divided in half. An $80-per-share purchase price would become $40 per share after a two-for-one split.

Reporting methods

There are four ways of tracking and reporting your cost basis, each with unique effects and target audiences.

First in, first out

First in, first out, or FIFO, considers the shares you've held the longest to be the first shares sold. These shares often have the lowest cost basis and may result in higher taxes.

This is a straighforward, uncomplicated method, so it should be used by investors who don't wish to track investments individually.

Specific share identification

In this method, specific shares are identified when placing a sell order. This can't be automated and must be done manually.

Specific share identification allows the greatest control over realization of gains and losses, but it's time-consuming and may be costly if using an advisor because you have to select the specific asset and account for short- and long-term capital gains, wash sale rules, tax-loss harvesting or amount of capital gain generated.

Average cost

The average cost method divides the total cost of shares owned by the total number of shares. If used for cost basis reporting, it must be used for all shares bought before the initial stock sale. While simple to implement, the average cost method doesn't necessarilly produce the lowest tax payment.

It may be used for mutual funds, exchange-traded funds and exchange-traded notes. The average cost method may be good for investors who want a simple method of tracking or employ dollar cost averaging.

Last in, first out

Last in, first out, or LIFO, assumes you sold the most recently purchased shares. This can work well in a rising market because it will result in reduced capital gains. However, the holding length must be considered to determine if the investment qualifies for short- or long-term rates.

LIFO can be good for investors looking to defer higher gains in a rising market and sell higher-cost shares.

Reporting methods example

The best way to understand how each of these methods works is to walk through four examples. Below is a list of hypothetical investment amounts and purchase dates of Company A shares.

• First purchase: 6 years ago, 100 shares, $15 per share—$1,500 investment
• Second purchase: 3 years ago, 100 shares, $50 per share—$5,000 investment
• Third purchase: 6 months ago, 50 shares, $75 per share—$3,750 investment
• Total investment: 250 shares—$9,750

If you sold 100 shares of Company A—which is selling at $80 per share—here are the effects of each cost basis method, assuming rates of 20% for long-term capital gain and 33% short-term capital gain.

The method you choose has tax implications that vary broadly, so the one you select should include a broader consideration of your tax needs, such as tax bracket management or tax-loss harvesting.

Similarly, you'll want to include your tax advisor in your decision-making and give yourself enough time before filing your returns to make the most tax-advantaged decision. Without direction from you, brokerage firms typically default to the FIFO method to report cost basis.

Other asset types

When it comes to tax basis, there's additional information to understand when dealing with other asset types. For example, bonds are treated differently than shares. The purchase price above or below par must be amortized until maturity and is spread out over the life of the bond. Since the cost basis is decreased each year by the proportionate amount that you paid a premium above par value, more of your interest payments are subject to ordinary income tax.

Per the IRS, the responsibility is on you as the investor to track and maintain information regarding your cost basis—although brokerage firms must report an asset sale to the IRS if the investment was made after the following dates:

• January 1, 2011, for equities
• January 1, 2012, for mutual funds, exchange-traded funds and dividend reinvestment banks
• January 1, 2014, for other specific securities, fixed-income securities, bonds and options

Inherited or gifted shares

The last thing to keep in mind is any investments you inherited get a step-up in basis to the fair market value at the time of the benefactor's death. It can be either the date of death or 6 months later depending on fair market value, so you'll need to speak with the executor or accountant who completed the estate return to find out which valuation date was chosen and the appropriate value. You'll only recognize gain for any appreciation from that date forward.

If you were gifted shares or other investments, the basis your donor had is carried over to you instead of being stepped up to the current fair market value. Because of this stipulation, it's important to get the cost basis records—including any reinvested dividends, et cetera—from your parent or donor in that case, if you plan to sell the shares later.

The bottom line

Cost basis calculations can become very complex. However, as the example showed, it can be the difference in many thousands of dollars in taxes owed if you take the time to track your cost basis and select the reporting method that works best for your current situation.

To learn more about the options regarding cost basis calculations for your portfolio, speak to a First Citizens wealth consultant today.