Cost Basis: What You Need to Know at Tax Time

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Selling an investment typically has tax consequences. To figure out whether you need to report a capital gain -- or can claim a loss -- after you sell, you need to know the cost basis for that investment.

For stocks or bonds, the cost basis is generally the price you paid to purchase the securities, including purchases made by reinvestment of dividends or capital gains distributions, plus other costs, such as the commission or other fees you paid to complete the transaction. This information is typically included on the confirmation statement that the broker sends you after you purchase a security.

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You -- the taxpayer -- are responsible for reporting your cost-basis information accurately to the IRS. You do this in most cases by filling out Form 8949. (For tax history junkies, this form replaced the Form 1040 Schedule D-1 in tax year 2011 for most cost-basis reporting.)

But fear not. You're not on your own when it comes to computing cost basis. In 2008, Congress passed a law that requires brokerage firms, mutual funds and others to give you a hand.

Brokerage firm responsibilities

In its Cost Basis Reporting FAQs, the IRS lays out what information brokerages and other financial institutions must provide with respect to cost-basis reporting. Currently, brokerage firms must report cost basis and the type of capital gain (short-term or long-term) on Form 1099-B (or a substitute statement) for the sale of certain securities. This generally includes: shares of corporate stock that you acquired after 2010; shares of stock in mutual funds acquired after 2011; shares of stock acquired in connection with a dividend reinvestment after 2011; and certain other types of securities such as debt instruments and options acquired after 2013.

If you sold any of these securities last year, you should have already received a copy of any 1099-B or substitute statement from your brokerage firm by now (customers usually receive 1099s by Feb. 15). Review this information as soon as you get it. Check that the cost basis your broker reported to the IRS matches your own records -- and if the amount differs, contact your broker immediately to discuss any differences you find.

There are situations, however, in which a firm may not be required -- or is simply unable -- to provide a cost basis for a sale. This could be the case if the securities you sold were purchased many years ago or if you transferred your holdings from one securities firm to another before the new reporting requirements went into effect.

If you have questions about what sales are reportable by your brokerage firm, you shouldn't hesitate to contact your financial professional. Many firms also have a section on their website explaining cost basis and the specific cost-basis information they provide to their customers.

You have a choice

If you purchased shares of the same company (or mutual fund) at different times and prices, you have a choice when it comes to deciding which shares to sell for the purpose of cost-basis accounting. If you can adequately identify the shares you sold (by keeping careful records of which shares you bought when and how much you paid), then you can use your cost basis for those specific shares. The IRS calls this "specific share identification."

If you cannot determine exactly which shares you are selling, or don't wish to go through the bother, you can calculate a gain or loss as if you are selling the earliest acquired shares. This method is called "first in first out" (FIFO).

Here's how FIFO works: Let's say you sell 200 shares of a 2,000-share portfolio that you purchased over time. With FIFO, the IRS expects you to use the price of your oldest shares -- the ones you purchased or otherwise acquired first -- to compute your cost basis. Especially for buy-and-hold investors, the oldest shares often wind up being the least expensive, resulting in a lower cost basis and thus a larger tax bill.

For limited types of sales, including those involving shares of mutual funds or shares of stock obtained through a dividend reinvestment plan, you also might be eligible to elect the average cost method as a way to figure your cost basis. The IRS has information on how this method works.

It's a good idea to contact your firm or financial professional before you sell securities to make sure you are on the same page when it comes to the type of cost basis method you intend to use. Firms generally provide information about cost basis and use the IRS default (FIFO) unless you select a different method.

4 record-keeping tips

While brokerages have cost-basis reporting obligations, it's still important to keep good records of your transactions. After all, the IRS holds the individual investor (not your financial institution) responsible for accurately reporting cost basis. Here are some tips:

  1. Hold on to trade confirmations showing how much you paid for specific shares and file them in an easily accessible place so you can find them come tax time. This is particularly important if you purchased shares of the same company at different times and prices and plan to use "specific share identification" as mentioned above.
  2. Keep track of stock dividends or non-dividend distributions you receive, because they may affect the cost basis of your shares.
  3. If you received the securities as a gift or through an inheritance, you may have to find out the fair market value of the securities when they were given to you, or you may need the previous owner's adjusted basis. It's important to keep that information in a safe place for easy reference later.
  4. Need help? Check out IRS Publication 550. It offers detailed guidance on how to calculate cost basis under different circumstances. It's also a sound practice to consult with a tax professional when computing and reporting a gain or loss.

The bottom line is that the IRS expects you to keep and maintain records that identify the cost basis of your securities. If you do not have adequate records, you may have to rely on the cost basis that your broker reports -- or be able to justify to the IRS the cost basis you use. For this reason, you may want to check whether you have cost basis information for any securities you want to sell before you do so.

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