32.10 Comparison of Basis Methods

Your choice of basis method can have a significant effect on the computation of capital gains and losses when you sell a portion of your shares in a mutual fund (32.9). The following example compares the average cost method to the specific identification and FIFO methods.

Transaction history.

Assume that on February 8, 1993, you made an initial investment of $4,500 for 375 shares in ABC Mutual Fund at $12 per share. Under the dividend reinvestment plan, you reinvested a $400 dividend, received in December 1993, for an additional 40 shares at $10 per share. On June 10, 1994, you bought 350 shares at $15 per share. In December 1994 you reinvested your dividend, this time for 25 shares at $12 per share. On September 14, 1995, you bought 200 shares at $16 per share. On August 17, 2006, you bought 200 shares at $25 per share. You did not reinvest your dividends received after 2004 and did not buy any more shares after August 17, 2006 or sell any of the shares.

Now assume that you are planning to redeem some of your shares in 2013 and are trying to decide whether to use the average cost, specific identification, or FIFO method for figuring basis. Since all of your shares have been held long term, capital gain or loss will be long term regardless of which basis method is used.

You decide to redeem 200 shares on October 18, 2013, when shares are selling at $20 per share. The table below shows your transaction history and following that is a comparison of how the three basis methods would work given these facts.

Transaction History

Specific identification method.

If you identify the particular shares you are selling, you can use the basis of those shares to figure your gain or loss. You must specify the particular shares to be redeemed at the time of the sale, and must receive a written confirmation of your specification within a reasonable time. Depending on your situation, you may want to either maximize or minimize your gain or loss on the sale.

Assume you want to realize a loss that can be used to offset other gains. You would specify the 200 shares purchased at $25 per share on August 17, 2006, as the shares sold. Since the sales price on October 18, 2013 was $20 per share, the loss would be $5 per share, for an overall long-term capital loss of $1,000 ($4,000–$5,000).

On the other hand, if you realized a gain, you could offset some capital losses that you realized earlier in the year, but you want to minimize the gain. You would specify the 200 shares bought at $16 per share on September 14, 1995, as the shares sold. Since the shares were sold for $20 per share, the gain would be $4 per share, for an overall $800 long-term capital gain ($4,000 − $3,200).

Caution

Get Written Confirmation for Specific Identification Method

If you want to take advantage of the specific identification method, make sure the fund sends you a written confirmation of your selling instructions.

The specific identification method allows you to designate specific shares as the shares sold, allowing you to minimize a gain on the sale or to select shares that, because of their basis, would give you a loss.

- - - - - - - - - -

FIFO (first-in, first-out).

Under the FIFO method, the oldest shares, the February 8, 1993 shares, are considered sold first. Thus, the basis of the 200 shares sold would be $12 per share. Your long-term capital gain is $1,600 ($4,000 − $2,400).

Average cost.

Assume that the ABC Mutual Fund has calculated your average basis and provides it on your account statements. Your average cost is $15.67. This is your total investment of $18,650 divided by the 1,190 total shares. At $15.67 per share, the total cost is $3,134 for the 200 redeemed shares. Your long-term capital gain is $866 ($4,000 − $3,134). The shares sold are considered to be from the earliest lot in 1993.

Conclusion.

Given this transaction history and preferred gain or loss objective, the specific identification method is advantageous. It allows you to realize a loss if that is your preferred tax result, or to realize the lowest capital gain if that is your preferred tax result.