It’s hard enough deciding when to sell securities, but now there’s an additional choice to be made—which accounting method you want to be used in calculating shares’ “cost basis,” which is used to determine how much tax you’ll owe if you made a profit. Under new rules, unless you specify otherwise, the financial institution handling the sale will use a default method that may leave you at a disadvantage. So it’s important that you fully understand your options.
Under a 2008 law, the rules are being phased in over three years. Your broker must provide the pertinent cost basis information for federal income tax purposes on the Form 1099-Bs you receive each year. The new rules apply to the sale of securities purchased:
- After 2010 for domestic and foreign stocks, American Depository Receipts (ADRs), real estate investment trusts (REITs), and exchange-traded funds (ETFs) that are taxed as corporations;
- After 2011 for mutual funds, dividend reinvestment plans (DRPs), and other ETFs; and
- After 2013 for other securities, including stock options, fixed-income investments, and debt instruments.
For example, if you bought stock before 2011, the new cost basis rules don’t apply to the sales of those securities, but they do apply to mutual fund shares acquired and reinvested in 2012. Because you’re still personally responsible for calculating the basis on the sale of all securities purchased before 2011, the old and new rules will co-exist for years to come.
Significantly, you can no longer choose an accounting method at tax return time for shares of the same security that you acquired at different times and at different prices. If you don’t choose a method when you sell, the broker will rely on a default method. The default for stocks is the first-in-first-out (FIFO) method, while the default for mutual fund shares is generally the average cost method, though you should check with the broker to determine the exact method for mutual fund shares.
Investors generally can choose from among six basic accounting methods:
1. First-in, first-out (FIFO). As the name implies, the first shares you acquired are considered to be the first shares sold. If you bought the shares at a low price and they have appreciated in value, this method may produce a large taxable gain.
2. Last-in, first-out (LIFO). This is the reverse of FIFO; here, the last shares you acquired are considered to be the first you’ve sold. Normally, this will produce a smaller taxable gain than FIFO—or a loss if the value has declined—but it depends on the situation. Another consideration is that choosing LIFO could mean that your profit is considered a short-term, rather than long-term, capital gain and so won’t qualify for a more favorable tax rate for long-term gains. Instead, your gain will be taxed at ordinary income rates currently as high as 35%.
3. Highest cost method. Under this method, the first shares sold are considered to be those with the highest cost basis, regardless of when you acquired them. This method tends to maximize losses and minimize gains. But here, too, capital gains could be considered short term for tax purposes if the shares sold were purchased within the past 12 months.
4. Lowest cost method. The flip side of the highest cost method, the lowest cost method assumes that the shares with the lowest cost are sold first. This tends to produce larger gains; you might use it if you’re also taking losses that could offset those gains.
5. Average cost method. This approach, often the default method for mutual funds, adds up the total cost basis of your shares and divides that by the total number of shares to find the “average cost” per share. This method generally simplifies the process and will provide results that can minimize the ups and downs of the market. One drawback in choosing this method is that it will be locked in for future sales of this security, so you can’t cherry-pick gains and losses for tax purposes.
6. Specific lots method. This method allows you to identify specific shares you are selling at the time of the transaction. It’s requires more forethought than the other methods, but it can help a tax-savvy investor maximize annual tax benefits by selecting lots that will produce gains or losses, depending on the investor’s need.
Which method should you choose? There’s no right or wrong answer. In some cases, you might simply use the broker’s default method, while in others it may be better to choose an alternative. We can help you analyze your situation and figure out the best approach.