Patient investors have generally prospered over the long term. Nevertheless, there are many reasons for selling stocks. Knowing the basics can help improve your tax position.
Selling shares held in a taxable account will trigger taxable capital gains or losses, unless the sale proceeds are exactly the same as your basis ― your cost for tax purposes. If you are making a complete sale from an investment position, the calculation of basis is fairly simple. It’s just the total cost of all the shares you have purchased (including reinvested dividends) at the time you purchased them.
Many fund companies will track purchases and dividend reinvestments for shareholders; the companies also will report the amounts of long-term and short-term gains (reflecting whether assets were held for more than a year), which are taxed at different rates. Not all fund companies provide complete records, so it’s a good idea to keep careful track of your securities transactions.
The situation is different if an investor sells just part of a position in a security. Investors who find themselves in this position can choose among multiple options for tax reporting.
First in, first out (FIFO). Using the FIFO method, shares that are sold are assumed to be sold in the order you purchased them. In other words, using FIFO, you will always sell the shares that you have held the longest.
The disadvantage of choosing FIFO is that the taxable gain may be high after a long period of stock market growth. On the other hand, the entire sale may qualify as a favorably taxed long-term capital gain, if all the shares were held for more than a year.
Specific identification. As the name indicates, with this method the investor designates the specific shares to be sold. By selling the shares with the highest purchase prices, an investor may be able to minimize his or her capital gain or obtain a capital loss, which can provide tax benefits. This method requires careful record keeping, and you will have the burden of proving the basis in the designated shares at the time of the sale.
Average cost. The FIFO and “specific identification” methods are available to all investors, whether they hold mutual funds or individual securities. The “average cost” method, however, is available only to mutual fund investors and to investors in certain dividend reinvestment plans.
With this method, you divide the amount you have invested and reinvested in a given fund, before a sale, by the number of shares you held then. If you choose this method, you must use it for all future sales of that fund’s shares.