The landscape · Investing and taxes
Cost basis methods, specific identification versus average cost
When only some shares of a holding are sold, the method used to decide which shares were sold sets the gain or loss, and the methods the IRS allows give different answers.
Who this exists for. This applies when a person sells part of a holding bought at different times and prices in a taxable account. Ticks that show it: I hold investments outside retirement accounts; My employer offers stock or a stock purchase plan.
How it works
The default at most brokers is first in, first out, which treats the oldest shares as sold first. Specific identification lets the seller tell the broker, before the trade settles, exactly which lots are sold, which allows picking the highest cost shares to minimize gain or the shares with the longest holding period for the long term rate. For mutual funds, and only for mutual funds, average cost is also allowed, which pools every purchase into one average price per share, and once used for a fund it must be kept for that fund. Brokers have been required since 2011 to report basis on shares bought after that date, and the method on file with the broker is what gets reported. Shares received as gifts carry the giver's basis, and inherited shares carry the value at death.
What it gives
Specific identification can cut the gain on a sale by picking the highest cost shares.
The long term rate can be protected by choosing lots held more than a year.
Average cost is simple and requires no lot tracking for a fund with years of reinvested dividends.
What it costs, or where the catch is
The lot choice must be made at or before the sale, not at tax time.
Average cost, once chosen for a fund, locks in for that fund.
Shares bought before the broker reporting rules may have no basis on file, and the owner has to reconstruct it.
A worked example
Rhea owns 300 shares of a fund: 100 bought at $40, 100 at $60, and 100 at $80. She sells 100 shares at $90. First in, first out sells the $40 lot for a $5,000 gain, since $9,000 minus $4,000 is $5,000. Specific identification lets her sell the $80 lot for a $1,000 gain. Average cost gives a basis of $60 a share and a $3,000 gain. Same sale, three different tax bills.
Where it goes wrong
The common miss is leaving the broker on its default and discovering at tax time that the oldest, cheapest shares were sold.
Who confirms it for you
For your own numbers, a CPA or enrolled agent. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.
The official source
IRS Publication 550, Investment Income and Expenses. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.
Ask about Cost basis methods, specific identification versus average cost
A model reads this page and answers from it. It will say when the answer is not on the page. Education, not personalized advice.
Nearby doors
- The employee stock purchase plan discount
This exists for a worker whose employer offers an employee stock purchase plan that sells company shares at a discount through payroll.
- I bonds and Treasury bills through TreasuryDirect
This exists for a person holding cash they do not need for a while, who wants to know what the Treasury sells directly to individuals.
- FDIC and NCUA insurance limits and ownership categories
This exists for anyone with money in a bank or credit union, and especially for a person whose balances at one institution are approaching the insured amount.
- Quarterly estimated taxes and the safe harbor
This applies when a person expects to owe at least $1,000 of federal tax beyond what is withheld, which is the usual case for self employed people and those with large investment income.
- The kiddie tax on a child's investment income
This applies when a child under 18, or a full time student under 24, has investment income above a line set each year.
- Charitable giving with cash versus appreciated stock
This exists for a person who gives to charity and holds investments that have grown in value.
Education, not advice. Wealthy Habitat explains how rules work and never recommends what to do with your money. The No Advice Disclosure.