A lot of people don't like to think about taxes, so much so that they ignore the topic until tax season arrives. Unfortunately, waiting until the last minute to sort out tax matters can mean you miss opportunities to potentially lower your tax bill.
Investors who incorporate tax planning into their investment strategy could reap significant tax benefits over the long term, says Hayden Adams, CPA, director of CFP® financial and tax planning at the Schwab Center for Financial Research.
Don't just think about capital gains and losses. Experienced investors know how to manage the so-called "cost basis" and holding periods of their investments to reduce taxable gains. Knowing your cost base can be a valuable tool.
What is the cost basis?
Simply put, your cost basis is what you paid for an investment, including brokerage fees, "encumbrances," and all other trading costs, and it can be adjusted for corporate actions like mergers, stock splits, and dividend payments. This is important because your capital gain (or loss) is the difference between the cost basis and the price at which you sell your securities. This cost is easy to calculate if you don't reinvest the dividends or average dollar cost when investing.
But if you're buying over time, even automatically through a dividend reinvestment plan, each block of stock you buy will likely have a different cost and holding period. This allows you to choose between high or low cost and long or short-term stocks when selling, making the sale your best tax benefit.
Alternatively, you can opt for the standard automatic method, which requires less effort on your part but may cost you more in taxes.
It's also important to note that determining the cost basis of bonds can be a bit more complicated depending on whether you bought them at "par" (par value), paid a premium, or received a discount. Fortunately, bonds purchased from 2014 onwards are now required to be presented by the brokerage firm to each investor with tax documentation that includes the asset's cost basis.
reporting rules
Federal tax regulations require brokerage firms to report their cost basis to the IRS when selling an asset only if that asset was purchased after one of the following dates:
- Stocks (stocks, including REITs) purchased on or after January 1, 2011
- Mutual funds, ETFs and dividend reinvestment plans purchased on or after January 1, 2012
- Other Specified Securities, including most fixed income securities (generally bonds) and options that vest on or after January 1, 2014
Whether or not a broker reports your cost basis to the IRS, you are responsible for reporting the correct amount when filing your tax return. And the cost-basis method you choose to identify the stocks you sell can make a big difference in how much you end up paying. To understand why, you need to know a little bit about how the IRS views cost-based accounting.
First-in-first-out-Methode
The FIFO (first-in, first-out) cost basis method is Schwab's standard method of determining which assets have been sold for all investments other than mutual funds, unless you specify otherwise.
If you bought 1,000 shares and sold 100 of those shares over a number of years, the FIFO method assumes that the shares you sold were the first ones you bought (the oldest shares). Generally, the stocks you've held the longest are the ones you bought at the lowest cost, meaning the FIFO method could result in the highest recognized profit and highest tax liability.
Specific identification method
The other single-share option is called the "specific identification" method. The specific identification method requires a little more effort, but allows you to choose which shares are sold and gives you the most flexibility and potentially the lowest tax liability. Let's look at an example of how specific identification works.
Let's say you bought 500 shares of XYZ Corp. 10 years ago. at a price of $10 per share ($5,000 total) and paid a $50 brokerage fee for a total cost of $5,050 ($10.10 per share). A few years later, he bought a second batch of 500 shares at $60 per share ($30,000 total) and paid a $10 commission for a total of $30,010 ($60.02 per share).
Now let's assume that the value of this stock has continued to increase and each share is now worth $100. You want to liquidate 100 shares (assuming a $10 sales commission). Depending on the method you use, you may owe taxes on $8,980 or as little as $3,988 in earnings. (See the table below for more details.)
Calculate the cost carefully to pay less tax
Calculate the cost carefully to pay less tax
By specifically identifying the stocks you wish to sell, you will owe much less capital gains tax in this hypothetical example.
| Method | Cost | Product | appreciation |
|---|---|---|---|
| FIFO | 1.010 $ (100 shares x $10.10/share) | 9.990 $ | 8.980 $ |
| specific identification | $6.002 (100 shares x $60.02/share) | 9.990 $ | 3.988 $ |
- Fuente
Schwab Center for Financial Research.
The example is hypothetical and for illustrative purposes only.
Identification of Actions
How do you identify the specific stocks you want to sell?
If placing the order over the phone, tell your broker which stocks you want to sell (e.g., "The stocks I bought on July 5, 2012 at $11 each").
When you order online from Schwab, you will see your cost basis method on the order entry screen. If you choose the "specific lots" method, you can specify exactly which lots you want to sell.
Cost basis options for mutual funds
Mutual fund investors have an additional cost basis method they can use called "average cost, single category." This method determines your transaction cost basis by taking the average cost of all the shares you own and multiplying it by the number of shares you are selling. This method offers the easiest way to handle mutual fund sales if you're reinvesting dividends and/or regularly adding to your holdings.
There is one major disadvantage to using the average cost method. If you choose this method for your first sale, you must continue to use it for any subsequent sale of Shares purchased prior to that sale date. Choosing a specific ID allows you to choose which stocks to sell, potentially saving you money.
For example, let's say you buy mutual fund shares each month through an automated investment plan. In a month, the stock could go up; next month they could be down. They pay little attention and simply invest the same amount each month, a process known as "dollar cost averaging."
Let's look at an example of how this works. Let's say you have 1,000 shares in a mutual fund and your lowest cost shares were bought for $10, your highest cost shares were bought for $100, and your average cost per share is $50. Today, the market value of shares in your mutual fund is $60 and you want to sell 100 shares. We ignore commissions here to keep it simple.
Let's compare the three ways your cost basis might be calculated (FIFO, average cost, and specific identification) and see what the taxable profit is in each what-if scenario.
Your cost basis can help you capture a profit or loss
Your cost basis can help you capture a profit or loss
| Method | purchase price | selling price | Capital Gain/Loss |
|---|---|---|---|
| FIFO | $10 | $60 | 5.000 $ ($50 x 100 shares) |
| Average cost, single category | $50* | $60 | 1.000 $ ($10 x 100 shares) |
| specific identification | $100 | $60 | -4.000 $ (-$40 x 100 shares) |
- Fuente
Schwab Center for Financial Research.
The example is hypothetical and for illustrative purposes only.
*The average price per share of the fund at the time of sale
As you can see from the table above, your taxable profit or loss can vary widely depending on the cost-based method you choose. Each of these transactions results in the same pre-tax cash flow of $6,000. However, depending on your particular situation, the money you have in your pocket after taxes can be very different with each method.
So which method should you choose?
One cost-based method is not necessarily better than another, as each has its pros and cons. Choosing the best cost-based method depends on your financial situation and specific needs.
If you have modest holdings and don't want to keep track of exactly when you've bought and sold stocks, it's probably okay to use average cost for mutual fund sales and FIFO for your other investments.
But if you're a tax-sensitive investor, specific identification could potentially save you a lot of taxes, especially if you employ other tax-smart strategies such astax loss recovery,collection of tax revenue, Öto donate valued goodsto your favorite charity.
Whichever method you choose, it's important to plan ahead so you don't have a huge tax bill to pay when tax season kicks off.
FAQs
How do I find my cost basis? ›
You can calculate your cost basis per share in two ways: Take the original investment amount ($10,000) and divide it by the new number of shares you hold (2,000 shares) to arrive at the new per-share cost basis ($10,000/2,000 = $5).
What is cost basis for tax purposes? ›Basis is generally the amount of your capital investment in property for tax purposes. Use your basis to figure depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange, or other disposition of the property. In most situations, the basis of an asset is its cost to you.
Which cost basis is best for me? ›Choosing the best cost basis method depends on your specific financial situation and needs. If you have modest holdings and don't want to keep close track of when you bought and sold shares, using the average cost method with mutual fund sales and the FIFO method for your other investments is probably fine.
Why is my cost basis lower than what I paid? ›Cost basis is the amount you paid for an investment, but it isn't always what you paid when you purchased it. Reinvesting dividends or capital gains will increase your cost basis.
How does the IRS know your cost basis? ›You usually get this information on the confirmation statement that the broker sends you after you have purchased a security. You—the taxpayer—are responsible for reporting your cost basis information accurately to the IRS. You do this in most cases by filling out Form 8949.
What happens if I don't know my cost basis? ›First of all, you should really dig through all your records to try and find the brokerage statements that have your actual cost basis. Try the brokerage firm's website to see if they have that data or call them to see if it can be provided.
What is cost basis example? ›Typically, when you purchase shares of stock, the cost basis is simply the price you paid for each share. Say you purchased 10 shares of XYZ for $100 per share in a taxable brokerage account. The total cost would be $1,000, and your cost basis for each individual share would be $100.
Does cost basis matter for taxes? ›Your basis is essentially your investment in an asset—the amount you will use to determine your profit or loss when you sell it. The higher your basis, the less gain there is to be taxed—and therefore, the lower your tax bill. This is why it's so important to accurately track the basis of any investment you own.
Does the IRS accept average cost basis? ›The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.
Why is my cost basis so high? ›Your sales proceeds and cost basis on your 1099-B may be much higher than your portfolio's earnings or balance was at any given time, because these proceeds represent the total amount of cash proceeds from the sale of securities, even if said proceeds were then used to buy securities again.
Can you change cost basis method every year? ›
Even if you've already selected—and even used—one of these cost basis calculation methods, you can change it for future sales whenever you want. * And you can apply those changes to just one fund or to all the funds within an account.
Can I change my cost basis method? ›You may not change a position's cost basis if it's coded with a known cost basis. To update an individual security's cost basis, you'll need to have an old statement or confirmation that indicates the cost you paid.
How do you reduce cost basis? ›The only way to reduce our cost basis is to limit profitability. By limiting profitability, we increase our probability of success. Reducing cost basis continually in long stock positions, allows us to generate capital and improve our probability of success in sideways markets.
Does the IRS know when you buy a house? ›The law demands that mortgage companies report large transactions to the Internal Revenue Service. If you buy a house worth over $10,000 in cash, your lenders will report the transaction on Form 8300 to the IRS.
Should I sell highest cost basis? ›In most cases, that means selling the shares with the highest cost basis — with the reasoning being that doing so results in the smallest capital gain (and therefore the lowest tax cost) or the largest loss (and therefore the greatest tax savings).
How do I fix cost basis in TurboTax? ›- Start at Investment income.
- Select Stocks, Mutual Funds ....
- Choose the Broker or Institution.
- Select the individual stock.
- The data you entered will be there.
- Toward the bottom of the screen select [I'll enter additional info on my own]
- In the entry for Box 2 enter Corrected Cost Basis.
If you do not report your cost basis to the IRS, the IRS considers your securities to have been sold at a 100% capital gain, which can result in a higher tax liability.
How do I know if my basis was reported to the IRS? ›This information can be found within the 1099-B section of your 1099 Composite statement. For non-covered securities, the information will be available under the area of the 1099-B that is not reported to the IRS.
Can you have 0 cost basis? ›Is entering 0 okay? Yes, if you are certain you didn't pay anything for these shares, then you can enter "0" as the Cost Basis. Before doing this, check with your employer's payroll department and make sure that the company did not include any "cost" for these shares in your taxable income (Box 1 of your Form W-2).
Why is cost basis important? ›The cost basis is important because it determines what you may or may not need to report as taxable income when you sell your stock shares. Cost basis is important in any investment, whether through equity compensation or another vehicle because it helps prevent being taxed on the same money twice.
What costs are included in basis? ›
- Property depreciation.
- Canceled debt not included with income.
- Previously deferred, or postponed gain from a property sale (such as that used with a 1031 exchange)
- Insurance or other reimbursements for casualty or theft.
- Energy conservation subsidies.
- Amount received for easement grants.
- Sales price rebates.
The IRS allows cost basis to be determined using the first-in, first-out (FIFO) method (which is the default) or specific share identification. The latter allows the investor to identify which shares were sold, however, the designation must be made in advance to the brokerage—outlining which shares are being sold.
Am I taxed on proceeds or cost basis? ›When you sell a security, your tax liability is determined by how much you spent to buy the security (cost basis) and your sales price. If you sell a security for more than the original purchase price, the difference is taxable as a capital gain.
What can you included in the cost basis of property? ›- The original investment you made in the property minus the value of the land on which it sits.
- Certain items like legal, abstract or recording fees incurred in connection with the property.
- Any seller debts that a buyer agrees to pay.
Tax Matters
In 2008, Congress enacted mandatory cost basis reporting for brokers and mutual funds.
According to the IRS, taxpayers need to keep records that show the tax basis of an investment. For stocks, bonds and mutual funds, records that show the purchase price, sales price and amount of commissions help prove the tax basis.
Why does my cost basis keep going up? ›Reinvesting dividends increase the cost basis of a stock because dividends are used to buy more shares. 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.
How does the IRS know if you have capital gains? ›The Internal Revenue Service requires owners of real estate to report their capital gains. In some cases when you sell real estate for a capital gain, you'll receive IRS Form 1099-S. This form itself is sent to property sellers by real estate settlement agents, brokers or lenders involved in real estate transactions.
Does cost basis include repairs? ›Don't add to your basis costs you can deduct as current expenses. For example, amounts paid for incidental repairs or maintenance that are deductible as business expenses can't be added to basis. However, you can choose either to deduct or to capitalize certain other costs.
Which tax lot to sell first? ›The highest cost method selects the tax lot with the highest basis to be sold first. Put another way, the shares you paid the most for, are sold first. One thing to keep in mind, the highest cost method doesn't consider the length of time you own shares.
How do I find cost basis for old stock? ›
- Sign in to your brokerage account. ...
- Look at previous broker statements. ...
- Contact your brokerage firm. ...
- Go online for historical stock prices. ...
- Go directly to the source.
Tracking cost basis is incredibly important to make sure you don't overpay your taxes on capital gains in a regular taxable account. For IRAs, though, the rules are different, and cost basis plays a more limited role in how retirement accounts get taxed.
How do I fix cost basis in Turbotax? ›- Start at Investment income.
- Select Stocks, Mutual Funds ....
- Choose the Broker or Institution.
- Select the individual stock.
- The data you entered will be there.
- Toward the bottom of the screen select [I'll enter additional info on my own]
- In the entry for Box 2 enter Corrected Cost Basis.
Whether your small business focuses on real estate or sold unneeded property during the tax year, a copy of form 1099-S, which is sent to both you and the IRS by the closing attorney or real estate official, reports the gross proceeds from the sale.