Methods of Calculating Cost Basis

The IRS has stipulated four methods for calculating cost basis. The choice of cost basis method can have a significant effect on the computation of capital gains and losses when shares are sold and, as a consequence, on one's tax liability.

1. First In, First Out (FIFO)

According to this method, as the name suggests, shares are sold in the order in which they were purchased, often leading to substantial taxable gains because the longer the shares are held in a rising market, the more they're worth. This is the method generally used, but it shows higher capital gains and hence may not be the most advantageous as regards tax.

2. Single-Category Averaging

This method calculates the average cost per share for each share owned. As in FIFO, this method sells oldest shares first and is not necessarily tax efficient.

3. Specific Shares

This method is for meticulous investors who have kept careful and complete records of shares purchased by them. Depending on how long they have held the shares, they can ask the mutual fund to sell specific shares, preferably the ones they have paid the most for,since the smallest taxable gains would be earned. This method is hence more tax efficient but requires keeping of detailed records. One needs to remember, however, that gains are taxed at different rates depending on how long the shares have been held.

4. Double-Category Averaging

In this method, shares are divided into those with short-term and those with long-term gains and are then averaged for cost basis. Different tax rates apply to each type. The investors will have to give the mutual fund written instructions how many shares from each category they want to sell.

In order to calculate cost basis, therefore an investor will have to maintain a voluminous amount of records and statements relating to investments made, keep track of and account for corporate actions or events that alter the cost basis such as dividends, splits, etc. Each new action such as reinvestment of dividends, additional acquisition of a particular share already held or sale of any investment during the relevant period will necessitate the maintenance of a large amount of brokerage statements and confirmations as also recalculation of the tax basis. This is enough to give the average investor sleepless nights! For those with faint hearts it would be far more preferable to take the easy way out.