cost basis methods: FIFO, specific ID, average

In short

A friend of mine once sold some shares and could not tell me what he had paid for them. He knew the sale price to the penny. The purchase side was a fog. If you are holding shares you bought at different times, you will face the same fog, and it costs real money. Cost basis is what you paid for an investment, and the method you use to match sales against purchases changes your tax bill. Learn which method your broker uses by default, because that default applies unless you say otherwise. Tell your broker your choice before the sale settles, not after. Keep your own records too. They are your best defense when a number looks wrong.

The whole of it

What it is

I once watched a neighbor sort a coffee can full of receipts on his kitchen table. Each slip told a small story about when he bought something and what it cost. Your shares work the same way. Every purchase is a receipt with a date and a price, and cost basis is simply what you paid, including fees.

Why does it matter? When you sell, the IRS taxes the gain, not the whole sale. The gain is the sale price minus your basis. A higher basis means a smaller gain and a smaller tax bill. A lower basis means the reverse.

Now picture a single stock you bought three times at three prices. You sell only some of the shares. Which receipts did you just cash in? That question is what the three methods answer. They are FIFO, specific identification, and average cost. Each one is a rule for choosing which receipts to use.

How it works

If you are holding shares bought on several dates, here is how each method treats them.

FIFO stands for first in, first out. It assumes you sell your oldest shares first. If you do nothing, this is the method the law applies to stock. It is simple, and it needs no instructions from you.

Specific identification lets you pick the exact shares you sell. You might choose the ones with the highest cost, which shrinks the gain. You might choose shares held more than a year, because a long term gain is taxed at lower rates than a short term one. Holding period matters, so the date on each receipt matters too. The broker must carry out your choice, and Treasury rules require you to name the shares at the time of the trade. Many brokers let you do this on the order screen. Some need a phone call or a written note. Ask yours how it works.

Average cost is the third method, and it is only for mutual funds and certain other pooled holdings. It adds up everything you paid, divides by the number of shares, and gives each share the same basis. It is tidy. It also takes away your power to pick.

One more point is worth knowing. Brokers report basis to the IRS on Form 1099-B for most shares bought after certain dates. So the IRS already has a number. If your number differs, you must be ready to show why.

The numbers, and where to find yours

You have probably seen your holding period rule without noticing it. The line between short term and long term is one year and a day. The tax rates on long term gains come from the IRS and change by year, so see the current figure, which the official source publishes each year and the bracket thresholds at the current figure, which the official source publishes each year. Your ordinary income rate applies to short term gains.

Where do you find your own figures? Start with your trade confirmations. Each one shows the date, the price per share, and the fees. Your broker's cost basis page lists every lot, which is the word for one purchase of shares. Form 1099-B arrives each year with the sale proceeds and, for covered shares, the basis. IRS Publication 550, called Investment Income and Expenses, explains the rules in plain order. IRS Publication 551, called Basis of Assets, covers how to figure what you paid. Form 8949 and Schedule D are where you report each sale.

Also check the default setting on your account. Brokers must tell you which method they use, and many set it to FIFO for stock. For mutual funds, many default to average cost. Look, and do not guess.

A worked example

Let me tell you about Maria Delgado. She is a nurse in Ohio with a steady salary of $52,000. Over three years she bought shares of one company in three batches.

In year one she bought 10 shares at $20 each. That is $200. In year two she bought 10 shares at $30 each. That is $300. In year three she bought 10 shares at $50 each. That is $500. She now owns 30 shares, and she paid $1,000 in all.

This year the stock trades at $60. Maria sells 10 shares. The sale brings in 10 shares at $60 each, which is $600. What is her gain? It depends on the method.

Under FIFO, the oldest shares go first. Those cost $200. Her gain is $600 minus $200, which is $400. Those shares were held more than a year, so the gain is long term.

Under specific identification, Maria picks the year three shares. Those cost $500. Her gain is $600 minus $500, which is $100. That is a $300 smaller gain than under FIFO. But hold on. She bought those shares only a short while ago. If she sold them before one year passed, the $100 would be a short term gain, taxed at her ordinary rate. She would weigh a smaller gain against a higher rate. That is her call, and she can only make it if she names the shares at the time of the sale.

Under average cost, the rule applies only if these were fund shares, so suppose they were. The average basis is $1,000 divided by 30 shares, which is $33.33 a share, rounded. Selling 10 shares uses a basis of about $333. Her gain is $600 minus $333, which is about $267.

Three methods gave three gains: $400, $100, and about $267. The shares and the sale price never changed. Only the paperwork did. Maria made no mistake in any case. She simply learned that the choice was hers, and she made it with her eyes open.

Where it goes wrong

A fellow I know sold shares through an app and assumed the app would pick the cheapest tax answer. It did not. It used its default, and he paid more than he had to. Nobody did anything wrong. He just did not ask.

The first trap is silence. If you give no instruction, the broker uses its default. After the trade settles, you generally cannot go back and choose different shares. The window closes fast.

The second trap is thin records. If you moved shares between brokers, the old basis may not follow. The new broker might show a blank or a wrong number. The taxpayer carries the burden of proving basis, so keep old statements.

The third trap is the wash sale rule. If an investor sells at a loss and buys the same or a nearly identical investment within thirty days before or after, the loss is disallowed for now. The disallowed amount is added to the basis of the new shares. Basis tracking gets tangled here, so be careful.

The fourth trap is mixing methods. A broker may let the account holder switch methods, but the rules limit when and how for funds. Read your broker's notice before you assume.

Last, remember that dividends reinvested buy new shares. Each reinvestment is its own lot with its own date and price. Over many years that can mean hundreds of tiny receipts. Do not ignore them. They raise your basis, and a higher basis lowers your gain.

Questions to answer before you leave this page

Do you know which cost basis method your broker uses today for each account you own, and have you actually looked at the setting rather than assumed? If you hold mutual funds, is your account set to average cost, and did you choose that or simply inherit it? Can you find the purchase date and price of every lot you still hold, including reinvested dividends? Did any of your shares move from one broker to another, and does the new broker show the right basis? Before your next sale, will you tell your broker which shares to sell, and does your broker take that instruction on the trade screen, by phone, or in writing? Have you checked the current long term rates and thresholds on the IRS site, and do you know where your own income falls? And have you read IRS Publication 550 and Publication 551, or at least marked the pages you will want when tax season comes?