When you sell mutual fund shares, you must claim the gain or loss you realized on those shares. The capital gain or loss is the difference between the selling price and your cost basis. The tax rules give you several ways to determine what those shares cost, including using a first-in-first-out, or FIFO, designation.
Cost Basis Options
When you sell mutual fund shares, you have three choices for calculating the cost basis of the sold shares. The default choice when selling mutual fund shares is typically the average cost of the fund shares. Instead of average cost, you can use the FIFO method to select the sold shares or specifically identify -- by date of purchase and cost -- which shares were sold. Once you have selected the cost method for a specific mutual fund account, you must stick with that method whenever shares are sold.
First-in-first-out cost basis works like it sounds. If you sold 100 shares from your mutual fund account, you would use the 100 shares that have been in the account longest as the ones that were sold. The prices you paid for those shares will be the cost you claim. The shares can be from investments you made or from dividends or capital gains that were reinvested. The next time you sold shares, you would start with the 101st oldest share purchased and take the next group of shares as the cost of sold shares.
Mutual Fund Reporting
For any mutual fund shares you bought after Jan. 1, 2012, the fund company is required to include cost basis information on the Form 1099-B. If you plan to use FIFO as your cost basis, you should let the fund company know so the cost information on the 1099 matches the cost basis you use on your income tax return. Many fund companies will also calculate cost basis using the different methods for shares purchased before the effective date of the new rule.
When selling stock shares, the FIFO method tends to produce the largest capital gains, since the oldest shares are often the ones with the lowest cost. With mutual funds, capital gains distributions can reduce how much the share price has actually risen since you purchased the shares, either with cash or by reinvestment. If you plan to sell your fund holding in chunks, FIFO is an easier way to keep track of cost basis compared to calculating a new average cost after each sale of shares.
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.