How you report your mutual fund transactions can have a serious impact on the amount of taxes you pay at the end of the year. For those of you that are taking a passive approach on tracking your cost basis, it is possible that one of the following results could have ended up on your upcoming tax return.

Expected Result
The value of the mutual funds in your non-retirement account was down over 30%, so you sold some of those mutual funds, at a loss, to cover your living expenses for the year. The resulting sale produced a capital loss with plenty to carry over onto next year's tax return. (See if mutual funds are right for you in Getting To Know Hedge-Like Mutual Funds.)


Unexpected Result
The value of the mutual funds in your non-retirement account was down over 30%, so you sold some of those mutual funds, at a loss, but you receive a year-end Form 1099 that says you have a taxable capital gain of $50,000! Amazingly, it is possible to have an overall loss on a position but still have to pay taxes when you only sell a portion of the holding.


Avoiding the unexpected payment of capital gains tax can be accomplished by something as simple as changing the method that you use to track and record the cost basis for your individual holdings. When you don't sell 100% of a holding, the IRS gives you several ways in which you can allocate your remaining cost basis. Unfortunately, very few people have any idea what method they are currently using to track their cost basis. I would also guess that even fewer people realize they have multiple reporting methods from which they can choose. Before you can analyze your situation, you need to understand the basics about the methods that are available to you.

Methods for Tracking Cost Basis
First-in/first-out (FIFO) - This method will most likely be responsible for the unexpected taxable gains as it assumes the first shares acquired were the first shares that you sold. For people that have been accumulating a position in a mutual fund over a long period of time, this method will usually result in the largest realization of a gain. Unless you specify that you are using another method to track your cost basis, the IRS uses this method as the default method. (Learn about the easiest way to benefit from money market securities in Introduction To Money Market Mutual Funds.)


Example 1: Over time, you purchased four shares of the S&P, but sold one share in 2008 to cover your living expenses.

1 share was purchased in 1989 +$295
2 shares were purchased in 1999 +$1,286(x2)
1 share was purchased in 2007 +$797
4 shares total cost basis $3,664


The end result for the 2008 sale of one share of the S&P at $877 results in a gain of $582 ($877-$295). The painful part of this example is that the individual has a total loss on the position of $156 ($877x4=$3,508-$3,664) which the individual has accumulated over the past 20 years.

Average basis (single category) - Under this method, you must add up the total amount that you have purchased over time, which includes reinvested dividends and capital gains. Once you have added up the total purchases, you must divide the total purchases by the total number of shares. This average calculation provides you with a basis that you will use for all the shares, but the holding period for the shares that were just sold is determined on a FIFO basis. This method is most commonly used by mutual funds companies. (Cut out the middleman and the fees, read The Lowdown On No-Load Mutual Funds.)

Example 2: Over time, you purchased four shares of the S&P, but sold one share in 2008 to cover your living expenses.

1 share was purchased in 1989 +$295
2 shares was purchased in 1999 +$1,286(x2)
1 share was purchased in 2007 +$797
4 shares total cost basis $3,664


Each share in this scenario has a cost basis of $916 ($3,664 / 4). The end result for the 2008 sale of one share of the S&P at $877 is a loss of $39 ($877 - $916). While the cost basis is the average cost of the cumulative position, the character of the sale is still determined on a FIFO basis, so the sale is going to be matched to the one share purchased in1989, which results in a long term capital loss.

Average basis (double category) - This rarely-used method is very similar to the single category but it will divide the calculation into two parts, short-term (held one year or less) and long-term (held more than one year) shares. The average cost of shares in each category is then computed separately. This method results in additional record keeping and requires that written instructions be provided to your broker in advance of the sale so the broker is able to identify which category of shares is being sold. This method is rarely used by individual taxpayers because if you are going go through all the trouble of keeping records and identifying share categories at the time of sale, there is a better method available requiring roughly the same amount of effort, specific share identification. (Avoid unethical investments, read Socially Responsible Mutual Funds.)

Specific Share Identification
Under this method, you are allowed to identify the specific shares that you want to sell at the time of a sale. This method is the most flexible and allows you to identify the combination of shares that will yield the most favorable tax result. That said, this method requires you to keep thorough books and records, as the shareholder may need to prove the basis that is used in each sale. In addition, this method requires that you follow some additional formal procedures in identifying the specific lots at the time of sale.


1.You need to specify to your broker or agent the particular shares to be sold or transferred at the time of the sale or transfer.
2.You must receive written confirmation from your broker or agent within a reasonable time of your specification of the particular shares that were sold or transferred.


Example 3: Over time, you purchased four shares of the S&P, but sold one share in 2008 to cover your living expenses.

1 share was purchased in 1989 +$295
2 shares was purchased in 1999 +$1,286(x2)
1 share was purchased in 2007 +$797
4 shares total cost basis $3,664


In this scenario, we have the flexibility to identify the specific share that we want to sell, and harvest the largest loss. During the sale in 2008, we would prefer to realize the larger loss to offset other gains, so we sell the first of the two shares that were purchased in 1999. The sale price is going to be the same as in our previous examples, one share of the S&P at $877. The resulting loss ends up being $409 ($877 - $1,286). (Which country has the strictest rules on mutual fund construction? Find out in How Mutual Funds Differ Around The Globe.)

Putting it All Together
Once you have selected a method for calculating the cost basis for a particular fund holding, you generally cannot change your method to another cost-basis method without the approval of the IRS. However, you can select different methods for other funds you may own. For additional information on the four available methods, please refer to IRS Publication 564.


While all these methods seem like obscure calculations that your accountant will take care of at the end of the year, think again. Achieving the best result on an annual basis requires a proactive approach by you and your investment advisor in combination with your accountant. The benefits gained by the method you use can add to your bottom line. At the very least, sound planning will help you avoid the unexpected pain of paying taxes in a down year.

On a cautionary note, the recently passed Emergency Economic Stabilization Act of 2008 will be imposing complete cost-basis reporting requirements onto broker dealers over the next several years. Currently, broker dealers are only required to list the total sale values on your 1099 at the end of the year, so the purchase information on your tax return is solely reported to the IRS by you.

For those of you that receive gain/loss reports attached to your 1099, you can take heart knowing that they are only supplemental reports from your broker and that they are currently produced to give people guidance when preparing their taxes. The impact of the new legislation will mean that your brokerage firm's "guidance" will eventually be official correspondence to the IRS, because your broker dealer will eventually be required to report your capital gains directly to the IRS and to you. This ensuing change should reinforce the need to be proactive with your record keeping as FIFO isn't just another four letter word. (Not concerned about being an ethical investor? Maybe "sinful stocks" have a place in your portfolio, read Socially (Ir)responsible Mutual Funds.)


Filed Under:

comments powered by Disqus
Trading Center