## What is the 'Average Cost Basis Method'

The average cost basis method is a system of calculating the value of mutual fundÂ positions held in a taxable account to determine the profit or loss for tax reporting. The average cost is calculated by dividing the dollars invested in a mutual fund position by the number of shares. The average cost is then compared with the price at which the fund shares were sold to determine gains or losses for tax reporting. The average cost basis is one of many methods that theÂ IRSÂ allows investors to use to arrive at the cost of their mutual fundÂ holdings.

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## BREAKING DOWN 'Average Cost Basis Method'

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where your assets are held. Many brokerage firms default to the average cost basis method. Investors can also choose from other methods including: first in first out (FIFO), last in first out (LIFO), high cost, low cost and more. Once a cost basis method is determined for a specific mutual fund it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisorÂ orÂ financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Note that the cost basis only becomes important if the holdings are in a taxable account and theÂ investorÂ is considering a partial sale of the holdings.

## Cost Basis Comparisons

Cost basis comparison can be an important consideration. Assume that an investor made the following consecutive fund purchases in a taxable account: 1,500 shares at \$20, 1,000 shares at \$10 and 1,250 shares at \$8. The investorâ€™s average cost basis is calculated by dividing \$50,000/3,750 shares. The average cost is \$13.33.

Suppose the investor then sells 1,000 shares of the fund at \$19. The investor would have a capital gain of \$5,667 using the average cost basis method.

• Gain/loss using average cost basis: (\$19 - \$13.33) x 1,000 shares = \$5,667

Results can vary significantly by cost basis.

• First in first out: (\$19 - \$20) x 1,000 shares = - \$1,000
• Last in first out: (\$19 - \$8) x 1,000 = \$11,000
• High cost: (\$19 - \$20) x 1,000 shares = - \$1,000
• Low cost: (\$19 - \$8) x 1,000 = \$11,000

In this case, the investor would be better off if he or she had selected the FIFO method or the high cost method to determine the cost basis prior to selling the shares. These methods would result in no tax on a loss of \$1,000. With the average cost basis method, the investor must pay a capital gains tax on the gain of \$5,667.

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