When you earn profits on your investments, the government wants its share and collects that money in the form of capital gains taxes. You pay taxes only on the gains, which are your selling price minus the cost basis. If you end up with several different costs on an investment you sell, the tax rules allow alternative ways to determine the basis including an average cost.
Cost Basis Considerations
If you buy an investment one time and later sell that investment, it is pretty easy to determine the cost basis. Your cost basis is what you paid when the investment was made. However, if you make multiple purchases of the same investment -- such as a regular mutual fund investment program -- and then sell a portion of that investment, it is not readily apparent what specific purchases of the investment were sold.
If you sell an investment in which you have several different purchase costs, you can use one of three methods to determine the cost basis of the sold investments. For most investment types, the default cost basis is first-in-first-out, meaning you sold your oldest holdings first. Another cost basis choice is to designate which purchases you sold, noting by purchase date and price what was sold. The final method allowed by the tax rules is to calculate an average cost of the different prices you paid when buying into the investment.
Average Cost Restrictions
For many years, the average cost basis method could only be used with mutual fund investments. However, starting in 2011, stock shares purchased through a dividend reinvestment plan may be eligible for average cost basis cost accounting. Individual dividend reinvestment plans must meet certain Internal Revenue Service compliance requirements to use the average cost basis method. Note that only mutual fund and compliant stock dividend reinvestment plan investments can use the average cost basis method to determine cost basis when reporting capital gains.
Mutual Fund Reporting
Starting on January 1, 2011 for stocks and January 1, 2012 for mutual funds and stock dividend reinvestment plans, the broker or transfer agent that issues a Form 1099 for sold shares is required to include cost basis information on the 1099. If you want to use average cost basis or one of the other cost basis methods, contact the broker, mutual fund or transfer agent to let them know what cost method you will use to report capital gains. This way your cost basis will match the cost basis information received by the IRS.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.