Which Cost Basis Method Should You Use?

When you sell an investment, the resulting profit or loss has direct tax consequences. This outcome is found by subtracting your cost basis from the sale price. Cost basis is the original value of an asset for tax purposes, including the purchase price and any associated costs like commissions. The accounting method you choose to identify which shares you’ve sold can alter your calculated gain or loss, directly influencing your tax liability. This choice is a strategic decision that provides control over the timing and amount of your taxable gains.

Available Cost Basis Accounting Methods

The Internal Revenue Service (IRS) approves several methods for calculating the cost basis of securities. Each method provides a different way to determine which specific shares are considered sold when you dispose of a portion of a holding acquired at different times and prices.

First-In, First-Out (FIFO)

The First-In, First-Out (FIFO) method is the default for most brokerage firms for stocks and other securities. Under FIFO, the first shares you acquire are considered the first shares you sell. Because security prices have historically tended to rise over time, the oldest shares often have the lowest cost basis. Consequently, using FIFO will generally result in recognizing a larger capital gain when you sell.

For example, imagine you bought 100 shares of a company at $50 in 2020 and another 100 shares at $70 in 2022. If you decide to sell 100 shares in 2024 for $80 per share, the FIFO method dictates that you sold the first block of 100 shares you purchased. Your cost basis would be $5,000 (100 shares x $50), resulting in a taxable capital gain of $3,000 ($8,000 proceeds – $5,000 basis).

Specific Identification (Spec ID)

The Specific Identification method offers the most flexibility for managing your tax liability. This approach allows you to choose which specific lots of shares you want to sell at the time of the transaction. By selecting particular shares, you can strategically realize either long-term or short-term gains or losses to optimize your tax outcome. For instance, you might choose to sell shares with the highest cost basis to minimize your taxable gains, a strategy often called “HIFO” (Highest-In, First-Out).

Using the previous example, if you sold 100 shares for $80 each, you could use Spec ID to designate the shares purchased in 2022 as the ones being sold. In this case, your cost basis would be $7,000 (100 shares x $70), and your capital gain would be only $1,000 ($8,000 proceeds – $7,000 basis). To use this method, you must provide instructions to your broker identifying the specific shares to be sold at or before the settlement of the trade.

Average Cost

The Average Cost method is available only for mutual funds and certain dividend reinvestment plans (DRIPs). With this method, you calculate the average cost per share by dividing the total cost of all your shares by the total number of shares you own. This average price is then used as the cost basis for any shares you sell. Once you elect to use the average cost method for a particular fund, you may be required to continue using it for all shares in that account.

Suppose you invested in a mutual fund, buying shares for $2,000 and later for another $3,000, acquiring a total of 200 shares. Your total investment is $5,000, making your average cost $25 per share ($5,000 / 200 shares). If you sell 50 shares, your cost basis for the sale would be $1,250 (50 shares x $25). The IRS requires a written election to start or stop using the average cost method.

LIFO Is Not Permitted

It is a common misconception that the Last-In, First-Out (LIFO) method can be used for securities. While LIFO is a valid inventory accounting method for businesses selling goods, the IRS does not permit its use for determining the cost basis of stocks, bonds, or other securities.

Special Situations Affecting Cost Basis

Beyond the accounting method used at the time of a sale, certain events can legally alter the cost basis of your securities. These adjustments are mandated by tax law and can significantly change the calculation of capital gains or losses.

The Wash Sale Rule

The wash sale rule prevents investors from claiming a capital loss on a security if they purchase a “substantially identical” one within 30 days before or after the sale. This 61-day window is designed to stop taxpayers from generating artificial losses for tax purposes while maintaining their investment position. If a transaction is identified as a wash sale, the disallowed loss is not permanently lost; instead, it is added to the cost basis of the newly acquired replacement shares.

For instance, if you sell a stock for a $1,000 loss and then buy the same stock back 15 days later, you cannot deduct that $1,000 loss on your current tax return. The $1,000 disallowed loss is added to the purchase price of the new shares. The holding period of the original security is also added to the holding period of the new one.

Inherited Securities

When you inherit securities from a deceased individual, the cost basis is adjusted to the fair market value of the asset on the date of the original owner’s death. This is known as a “stepped-up basis.” This provision can provide a significant tax advantage to heirs, as it eliminates the capital gains tax on any appreciation that occurred during the decedent’s lifetime. The heir’s holding period for the inherited asset is automatically considered long-term.

For example, if your grandfather bought a stock for $10 per share and it was worth $150 per share on the day he passed away, your cost basis as the inheritor becomes $150 per share. If you later sell the stock for $160, you would only owe capital gains tax on the $10 difference.

Gifted Securities

The rules for securities received as a gift are different from those for inherited assets. Generally, the recipient of a gifted security takes on the donor’s original cost basis, a rule known as “carryover basis.” This means the recipient is responsible for the capital gains tax on all appreciation since the original purchase when they eventually sell the asset. The donor’s holding period also carries over to the recipient.

Selecting Your Method with Your Broker

Implementing your chosen cost basis accounting method is a procedural matter handled through your brokerage firm. It is important to understand how your broker’s system works to ensure your trades are treated as you intend for tax purposes.

Most brokerage firms assign a default cost basis method to new accounts, which is often First-In, First-Out (FIFO) for stocks and may be Average Cost for mutual funds. You can typically find your account’s default setting by logging into your brokerage’s online portal and navigating to the account settings or tax information section. Reviewing this setting is a good first step to ensure it aligns with your long-term tax strategy.

If the default method is not your preferred choice, you can usually change it for all future sales within your account. This change is also made through the brokerage’s website, often on the same page where you view the current default. Making this change establishes a new standing order for how your sales will be processed, but this change is prospective and won’t alter the reporting for past sales.

For investors who want maximum control, the Specific Identification method allows for a trade-by-trade decision. When placing a sell order online, the trade ticket or order entry screen will typically display the default cost basis method and provide an option to change it for that specific transaction. Selecting “Specific Lots” or a similar option will then allow you to view all your purchase lots of that security and choose the exact shares you wish to sell. This designation must be made at or before the settlement of the trade to be valid.

Reporting on Tax Forms

After a security is sold, the transaction must be accurately reported to the IRS on your annual tax return. Your brokerage firm provides a key document to facilitate this reporting, but the ultimate responsibility for accuracy lies with you.

At the end of the tax year, your broker will send you Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions.” This form summarizes all of your sales activity for the year. It details the gross proceeds from each sale, the date of the sale, and, for “covered” securities, the cost basis that was reported to the IRS. The form will also indicate whether the gain or loss is short-term (held one year or less) or long-term (held more than one year).

The information from Form 1099-B is used to complete Form 8949, “Sales and Other Dispositions of Capital Assets.” This form is where you list the details of each individual sale, reconciling the amounts on your 1099-B. Form 8949 is also where you make any necessary adjustments to the cost basis reported by your broker, such as for a wash sale loss that was disallowed. The form is divided into parts for short-term and long-term transactions.

Finally, the totals from Form 8949 are carried over to Schedule D, “Capital Gains and Losses.” Schedule D summarizes your total short-term and long-term gains and losses from all your Form 8949s. It is on Schedule D that your net capital gain or loss is calculated, which then flows to your main Form 1040 tax return. In some simple cases where no adjustments are needed, you may be able to report the summary totals from your 1099-B directly on Schedule D without filing Form 8949.