Cost-Basis Choices Not Set in Stone

Question: If I choose a specific cost-basis method when I open a mutual fund account, do I have to stick with that method as long as the account is open, or can I change to a different method at a later time?

Answer: Knowing which cost-basis method makes the most sense for you can be a tricky business, and cost-basis reporting rules have changed in recent years, so it's perfectly understandable if you're not quite clear as to what your choices are. Before we answer your question, let's first review how cost basis is used in tax calculations.

A Variety of Methods
Cost basis is the amount an investor has paid to acquire a security and is used to calculate any capital gain or loss, and therefore any taxes owed, once the security is sold (provided it is held in a taxable account--if held in a tax-deferred account such as a 401(k) no tax is owed until the investor begins taking distributions, at which time the investor will owe tax at his or her ordinary income tax rate). To use a simplified example, if an investor buys a share of stock for $10 and later sells it for $15, he owes taxes on the $5 gain, which represents the difference between the proceeds from the sale of the share ($15) and its cost basis ($10).

The Internal Revenue Service allows for the use of three basic cost-basis methods: 

• Average Cost: The cost basis of all shares is added together and the sum is divided by the number of shares in the account to produce an average; this method is only used for mutual funds.
  
  
• First In First Out (FIFO): Oldest shares are sold first.
  
  
• Specific Share Identification: The investor selects specific shares to sell. This method incorporates several different approaches, including: 
  Last In First Out (LIFO): Newest shares are sold first. 
  Highest In First Out (HIFO): Shares with the highest cost basis are sold first.
  Lowest In First Out: Shares with the lowest cost basis are sold first.
  Loss/Gain Utilization: Funds that have lost value are sold first, followed by those that have gained in value.

For a fuller discussion of these methods and help choosing one that works best for you, check out this article by Christine Benz, Morningstar's director of personal finance.

New Cost-Basis Reporting Rules Phased In
The requirement that financial institutions report shareholders' cost basis to the IRS is relatively new. As part of the 2008 Emergency Economic Stabilization Act, better known as the bailout of U.S. financial-services companies, fund companies and brokerages were required to phase in the reporting of cost-basis information to their customers and to the IRS. The first securities covered under the new regulations were equity and some exchange-traded fund shares acquired on or after Jan. 1, 2011. In 2012, the rules expanded to cover newly acquired shares of mutual funds, most ETFs, and dividend reinvestment plans. And in 2014, the cost-basis rules will apply for the first time to newly acquired bonds, options, and other types of securities.

On financial account statements, shares may be referred to as "covered" or "noncovered," which means they either are subject to new cost-basis reporting rules (covered) or are not (noncovered), depending on when they were acquired (some fund companies will provide an average cost basis for both covered and noncovered shares, but only covered-share cost basis is reported to the IRS). The basic distinction is that investors are responsible for tracking their cost basis and reporting their own capital gains and losses for shares that are noncovered. For covered shares, brokerage firms and fund companies must track and relay that same information to the IRS. A separate cost basis is calculated for each of these two classes of shares.

Default Methods for Funds, Stocks
Fund companies tend to use average cost as a default cost-basis method for mutual fund shares while brokerages tend to use FIFO as the default method for equity shares. However, investors can tell their fund company or brokerage they'd prefer to use a different method if they so choose. Why would an investor want to change cost-basis methods? It could be because he or she wants greater tax-management control over their portfolio or because their circumstances have changed.

Take, for example, an investor who has lost his job and as a result has fallen into a lower tax bracket in which he doesn't have to pay long-term capital gains. Assuming he's in one of the lowest tax brackets, the Lowest In First Out method allows him to sell shares with the lowest cost basis--and thus the largest capital gains embedded in them--without paying any taxes (provided the shares were held for at least a year). While it's true that the investor would pay no capital gains tax regardless of the cost basis method used in this case, by choosing to sell the lowest-cost-basis shares now, the investor gets those shares and their large embedded capital gains off the books. Once the investor returns to work and to a higher tax bracket, he may once again have to pay capital gains when selling his remaining shares, but the cost basis on those shares will be higher than the cost basis on the shares he sold previously, potentially resulting in a lower tax bill than if he had stuck with the average cost method, for example.

The Average Cost Caveat
Fund companies and brokerages may allow investors to change cost-basis methods online or by phone, but any change to or from the average cost method must be made in writing, according to IRS rules (email may be allowed). Investors may change cost-basis methods for unsold shares but not retroactively after shares are sold. An investor may even use different cost-basis methods within the same account--for example, using LIFO for the sale of some shares, FIFO for the sale of others--except when using the average cost method, for which special rules apply.

These average cost-basis rules differ slightly for covered and noncovered shares. For covered shares, if the average cost method has been chosen for the account but no shares have been sold using it, the account holder may change to a different cost-basis method without a problem. But once the average cost method has been applied to the sale of covered shares, that method must be used for the sale of any remaining covered shares in the account at that time. For example, an investor who buys 100 covered shares couldn't use the average cost method when selling 50 of those shares and a different method later when selling the other 50. He must use the average share method for all of them. However, the investor may choose a different cost-basis method for any new covered shares acquired after the sale of the original shares. So if, after selling the first 100covered shares and using the averaging method, the investor acquires another 25 covered shares, he doesn't have to use the averaging method when it comes time to sell those 25 newer covered shares.

For noncovered shares, once the average cost method has been used, the investor must continue using it for any remaining noncovered shares unless given permission from the IRS to change to a different cost-basis method. If you are unsure which of these rules applies to you or what cost-basis strategy will benefit you most, consult a tax professional. 

Whether selling covered or noncovered shares, ultimately it is the investor's responsibility to make sure that information on his tax return is accurate. It's easy to rely on your fund company or brokerage to provide cost basis and other capital gains information, but there's no substitute for diligence. Keeping your own records to check against what the fund company or brokerage is reporting in your name is always a good idea.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.