First What is cost basis? Cost basis is, generally, the price you paid for your shares. This includes adjustments such as reinvested dividends and capital gains, as well as any sales commissions or transaction fees.
Why you need to calculate cost basis? Keeping track of your cost basis is an important step in determining your capital gains or losses on sales of shares. The IRS requires you to report your gains or losses for shares sold when you file your annual tax return.
Under provisions of the Emergency Economic Stabilization Act of 2008, the U.S. Treasury has issued new regulations that will require investment companies and brokers/dealers to begin reporting to the IRS the cost basis of securities you acquire in 2011 or later and subsequently sell or transfer.
The Act’s requirements apply to firms involved in the transaction: brokers, custodians, transfer agents, etc. Although the legislation does not address financial advisers’ role directly, the new regulations nonetheless will influence advisers’ workflow and change the reports their clients receive from custodians.
The new rules phase in from January 1, 2011, through January 1, 2013, depending on the security’s type. Securities acquired before their class’s specified starting date are considered “uncovered” securities and brokers aren’t required to track cost basis for these securities. Securities acquired on or after their class’s specified date are “covered” securities and their basis and holding period must be tracked and reported.
The cost basis method you use can affect the capital gains or losses when you sell shares. In turn, it can also influence how much you owe in federal taxes. Therefore, it's important to give thoughtful consideration to your tax situation when choosing a method.
The following methods are approved by the IRS:
Cost basis is calculated based on the average price paid for all shares held, regardless of holding period. Gains or losses are defined as short-term or long-term based on the assumption that the oldest shares are sold first, even though the average cost is the same for all shares. This method of calculating cost basis is permitted for mutual funds only and cannot be used to calculate cost basis for individual securities such as stocks and bonds.
Pros to use average cost
Cons to use average cost
This method assumes that the first shares you acquired will be the first ones we sell. This method is available for mutual funds, stocks, and ETFs
Pros to use FIFO
Cons to use FIFO
This method lets you identify which shares you are selling, giving you the most control over the amount of realized gains and losses. The IRS requires you to identify specific shares (or lots) to your broker/dealer at the time you sell them. You may identify specific shares for sales of individual securities when you submit the trade. You are not permitted to make the determination after the fact. This method is available for mutual funds, as well as stocks and ETFs.
Pros to use specific identification
Cons to use specific identification
Cost basis is calculated on two average cost figures based on the holding period: one for short-term shares owned less than one year, and one for long-term shares owned more than one year. This method of calculating cost basis is permitted for mutual funds only; it cannot be used to calculate cost basis for individual securities such as stocks and bonds.