Determining the Cost Basis of Mutual Fund Shares

When you sell shares in a mutual fund you need to determine your cost basis in order to calculate your gain or loss on the sale for income tax purposes. Your basis is the amount you paid to purchase your shares in the mutual fund, plus the commission or load fee you paid. This basis may be adjusted over time for reinvested dividends.

When you purchase shares in a mutual fund over time, for example you invest a certain amount each month, the number of shares you purchase each time will vary according to fluctuations in the market value of the mutual fund shares. So when you sell a certain number of shares in the fund, or redeem a certain amount, you are selling shares that have a different cost basis, depending on when they were purchased.

If you keep good records, you can track the cost basis of the individual shares you have purchased in the mutual fund. And as indicated by TurboTax, if you want to sell shares you could direct the mutual fund to sell particular shares, for example shares you purchased on a specific date at a certain price. If you just direct the mutual fund to sell a certain number of shares or that you want to redeem a certain amount, the first in first out rule generally applies. The first shares you purchased are the ones that are sold.

In addition to the amount you paid for the mutual fund shares, including the commission, and any reinvested dividends, your basis can also be affected by undistributed capital gains and returns of capital distributions.

The mutual fund will send you a Form 2439 to report undistributed capital gains. The amount reported in box 1a of this form would be reported as a long term capital gain on Schedule D. You would add this amount to your basis in the mutual fund shares. You can claim a credit for the tax reported in box 2 of Form 2439 on line 71 of Form 1040.

Return of capital distributions are reported as non-dividend distributions in box 3 of Form 1099-DIV that you receive from the mutual fund. These distributions are not taxable and they reduce your basis in the mutual fund shares.

The IRS allows you to use an average method to calculate your basis in mutual fund shares to determine your gain or loss on a sale. There are two methods: the single category method and the double category method.

Under the single category method, you add up the cost of all your investments in the mutual fund and divide by the total number of shares you own to determine the cost basis of each share.

Under the double category method, you divide your mutual fund shares between short term (shares you have held for one year or less) and long term (shares held longer than one year). Then you divide the total cost for each category by the number of shares in each category to determine the cost basis per share.

Once you use an average cost method to determine your gain or loss on sales of mutual fund shares for income tax purposes, you have to continue to use that method for all accounts in the same mutual fund.

As reported by Vanguard, starting in 2012 mutual funds will be included among the entities that have to report cost basis information to investors and the IRS. Certain brokers have to provide this information starting in 2011. The cost basis is reported in box 3 of Form 1099-B.

Vanguard indicates that it currently provides the cost basis using the average cost method. Later it will also provide the first in first out method and the specific identification method, according to the individual investor's preference. You should check with your mutual fund company to see how cost basis information will be provided.

Sources:

Cost basis changes coming soon for mutual funds, Vanguard

Cost Basis: Tracking Your Tax Basis, TurboTax

Form 1040, U.S. Individual Income Tax Return

Form 1099-B, Proceeds from Broker and Barter Exchange Transactions

Form 1099-DIV, Dividends and Distributions

Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains

How do you calculate the cost basis for a mutual fund over an extended time period? Investopedia

Kaye A. Thomas, Basis of Particular Shares, Tax Guide for Investors

Mutual Funds (Costs, Distributions, etc.), IRS