Cost basis reporting

How the cost basis of an investment is determined will have a significant impact on how the investment is taxed when sold.  Here we will provide an overview of some of the most common cost basis conventions which are currently being used in the tax code for the 2016 and 2017 year.

First in, first out (FIFO)

With this method, the shares or units which were purchased first are the ones which are used to determine the basis when the asset is disposed of.  Another way of looking at this is that the shares which remain are the shares which were most recently purchased.  As an example, let’s say you purchase 100 shares of XYZ stock on September 1, 2016 for $5 per share, purchase another 50 shares of XYZ stock on October 1, 2016 for $10 per share and then sell 100 shares of XYZ stock on November 1, 2016 for $15 per share.  When using the FIFO method the basis for these shares would be $5 per share, or the price paid for the first 100 shares of XYZ stock on October 1, 2016.

Specific share identification (Spec ID)

With this method, the specific shares are identified upon the disposal of those shares.  Using the example above: upon selling the 100 shares of XYZ stock on November 1, 2016, these shares could be identified as the shares purchased on October 1, 2016, resulting in a basis of $10 per share, in contrast with the basis of $5 per share which would be the result of using the FIFO method.

Average cost single category

With this method, the average cost of the shares is calculated by dividing the total dollar amount of the purchases by the total number of the corresponding shares or units.  Using the example above, the total number of shares purchased would 150 and the total dollar amount of shares purchased would be $1,000, resulting in an average cost basis of $6.67 per share.

Highest in, first out

With this method, the shares with the highest cost are the shares which are sold or disposed of.  The purpose of using this method is to minimize the taxable gain within a specified period.  Using the example above, the 100 shares sold on November 1, 2016 would be identified as the 50 shares purchased on October 1, 2016 for $10 per share plus 50 of the shares purchased on September 1, 2016 for  $5 per share.  The basis in this case  would be $7.50 per share, which is the total dollar amount of the shares purchased divided by the number of shares sold.

Minimum tax

Under the minimum tax method, shares are sold in the order which minimizes taxable gains and maximizes tax deductible losses.  Specifically, shares are sold in the following order:  maximum short term capital losses, maximum long term capital losses, minimum long term gains and finally minimum short term gains.

Maximum gain

This method is the exact opposite of the minimum tax method in that it will tend to maximize the taxable gains, and would only be used in a situation where such an outcome would be advantageous, for example to offset against losses.   Using the maximum gain method, shares are disposed of in the following order:  maximum short term gains, maximum long term gains, minimum long term losses an finally minimum short term losses.

Capital gains and dividends

Investments can be be taxed in several ways.  When they are held inside retirement accounts, taxes are levied upon withdrawals from the retirement accounts based upon the rules related to those accounts.  When they are held outside of retirement accounts, they can be taxed on both the income which the investments generate as well as on the gains obtained when the investments are disposed of.

Income

We restrict discussion to dividends and interest here, and how they are treated for the recipient.  Income paid in the form of dividends and interest is typically taxable to the recipient upon being paid by the issuer or payer.  In the case where dividends are reinvested to purchase additional securities the dividends are still taxed upon being paid.  Dividends and interest are typically taxed as ordinary income, the exception being certain “qualified” dividends which are taxed at the capital gains tax rate.

Capital gains

Capital gains taxes are incurred when an asset is disposed of, and are based upon the amount of time which the asset is held.  Assets held for one year or less are taxed at the short term capital gains tax rate, while assets held for more than one year are taxed at the long term capital gains tax rate.  The amount of the gain is a function of the sales price and the cost basis of the asset.  The table below shows the capital gain tax rates for their corresponding income tax bracket.

2016 capital gains tax rates
Income tax bracket short term rate long term rate
10% 10% 0%
15% 15% 0%
25% 25% 15%
28% 28% 15%
33% 33% 15%
35% 35% 15%
39.6% 39.6% 20%

Income tax brackets

Below are the income tax brackets for the 2016 tax year.  These are the marginal tax rates, in that you will be taxed at each of these levels as your income rises.  For example, if you are single and had taxable income of $60,000, your tax would be the sum of 10% of $9,275, 15% of $28,375 ($37,650 minus $9,275), and 25% of $22,350 ($60,000 minus $37,650).  Capital gains tax brackets are different from income tax brackets.

2016 Income tax brackets
Rate Single Filer Married Filing Jointly Head of Household
10% $0 – $9,275 $0 – $18,550 $0 – $13,250
15% $9,276 – $37,650 $18,551 – $75,300 $13,251 – $50,400
25% $37,651 – $91,150 $75,301 – $151,900 $50,401 – $130,150
28% $91,151 – $190,150 $151,901 – $231,450 $130,151 – $210,800
33% $190,151 – $413,350 $231,451 – $413,350 $210,801 – $413,350
35% $413,351 – $415,050 $413,351 – $466,950 $413,351 – $441,000
39.6% >$415,050 >$466,950 >$441,000