Investors must pay taxes on any investment gains they realize. Subsequently, any capital gain realized by an investor over the course of a year must be identified when they file their income taxes. For this reason, being able to accurately calculate the cost basis of an investment, particularly one in a mutual fund, becomes extremely important.
The cost basis represents the original value of an asset that has been adjusted for stock splits, dividends and capital distributions. It is important for tax purposes because the value of the cost basis will determine the size of the capital gain that is taxed. The calculation of cost basis becomes confusing when dealing with mutual funds because they often pay dividends and capital gains distributions usually are reinvested in the fund.
For example, assume that you currently own 120 units of a fund, purchased in the past at a price of $8 per share, for a total cost of $960. The fund pays a dividend of $0.40 per share, so you are due to receive $48, but you have already decided to reinvest the dividends in the fund. The current price of the fund is $12, so you are able to purchase four more units with the dividends. Your cost basis now becomes $8.1290 ($1008/124 shares owned).
When shares of a fund are sold, the investor has a few different options as to which cost basis to use to calculate the capital gain or loss on the sale. The first in, first out method (FIFO) simply states that the first shares purchased are also the ones to be sold first. Subsequently, each investment in the fund has its own cost basis. The average cost single category method calculates the cost basis by taking the total investments made, including dividends and capital gains, and dividing the total by the number of shares held. This single cost basis then is used whenever shares are sold. The average cost double category basis requires the separation of the total pool of investments into two classifications: short term and long term. The average cost is then calculated for each specific time grouping. When the shares are sold, the investor can decide which category to use. Each method will generate different capital gains values used to calculate the tax liability. Subsequently, investors should choose the method that provides them with the best tax benefit.
To learn more, see Selling Losing Securities For A Tax Advantage, Using Tax Lots: A Way To Minimize Taxes and Mutual Fund Basics Tutorial.
You should take your original purchase amount, plus any dividends reinvested. The total is your new cost basis. Only the dividends reinvested within the last 12 months would be considered short term gains or losses.
The Investopedia answer pretty much covers it. Before going too crazy, I suggest contacting the fund company and asking them if they have the cost basis info. Many times they do (especially if you haven't transferred the account to a broker and it's been at the mutual fund company from day one).
Well, it used to be a daunting task for the investors, but the government’s rule has made it easier for everyone. IRS has made it clear that starting in 2011, brokers, which are your financial institutions, must report the adjusted basis and whether any gain or loss on a sale is classified as short-term or long-term from the sale of "covered securities," on Form 1099-B. The "covered securities," are a fancy name for corporate stocks acquired after 2010. Furthermore, the rule mentioned that brokers started to report the shares of mutual funds and stock acquired in connection with a dividend reinvestment plan after 2011, and debt instruments and options after 2013. Best!