Cost Basis Methods: FIFO, Specific Lot and Average Cost

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You bought the same holding three times over several years, at three different prices, and now you want to sell part of it. Which shares did you sell? The answer is not obvious, and it changes the gain you report. Cost basis methods are the rules for choosing which shares count as sold: first in, first out, specific lot identification and average cost are the three most common. Each can produce a different taxable gain from the same sale, so knowing which one your broker uses, and which ones you can choose, is worth a few minutes before you place the order.

Key Takeaways

• Cost basis is what you paid for an asset, adjusted for items such as reinvested dividends, and it determines your taxable gain or loss when you sell.
• FIFO treats the oldest shares as sold first, specific lot identification lets you choose, and average cost blends all purchases into one price.
• The same sale can produce different gains under different methods, so the method affects your tax bill and the holding period.
• Brokers apply a default method, but you can usually change it before the trade settles, and the choice generally has to be made in time.
• Average cost is limited to certain investments such as mutual funds, and a switch of method may require following specific rules.

Stage One: Know What Cost Basis Is

Cost basis is the starting point of every gain or loss calculation. In its simplest form, it is the price you paid for a security, including commissions and fees. It is then adjusted over time: reinvested dividends add to it, and certain distributions can reduce it. When you sell, your gain or loss is the proceeds minus the cost basis of the shares sold.

The IRS explains basis in its guidance on investment income, and Investor.gov offers an introduction for individual investors. Since 2011, brokers have been required to report cost basis to the IRS for most stocks and later for mutual funds and other securities, which is why the number on your Form 1099-B is usually prepared for you. The number still reflects a method choice, and the choice is yours to understand.

If you hold a single purchase of a security, the question never arises, because every share has the same basis. The need for a method appears when you have bought at different times and prices, which is the normal situation for anyone who adds to positions or reinvests dividends.

Stage Two: Understand the Default, First In, First Out

First in, first out, usually written FIFO, assumes the oldest shares are the ones you sell first. If you bought shares in three separate purchases and sell a portion, the sale is matched to the earliest purchase, then to the next once that one is exhausted.

FIFO is the default for most brokers on individual stocks if you do not specify otherwise. Its appeal is simplicity: it requires no decision and is easy to verify. Its effect depends on how prices have moved. If the earliest shares were bought at a lower price, FIFO tends to produce a larger gain, and because they are older, it also tends to produce a long-term result. If prices fell after the early purchases, the effect can be the reverse.

The trade-off, then, is between a simple, predictable record and the lack of control over which gain you realize. For an investor who rarely sells or whose purchases were all at similar prices, FIFO can be perfectly adequate.

Stage Three: Use Specific Lot Identification When Control Matters

Specific lot identification lets you choose which purchase lots a sale draws from. You tell your broker, at the time of the trade, which shares to sell, and the sale is matched to those lots.

This control is valuable. You can select lots with a higher basis to reduce a gain, lots with a longer holding period to qualify for long-term treatment, or lots with a loss when you want to realize one. A sale of shares from different lots can produce short-term and long-term pieces, and choosing deliberately changes the mix.

Specific identification carries requirements. The instruction generally has to be given to the broker no later than the settlement of the trade, and the broker's records need to confirm it. Many brokers let you set a standing preference, such as selling the highest-cost lots first, and override it trade by trade. Check how your broker handles it before relying on it, and keep your own records. Remember also that a loss sale followed by a repurchase can run into the wash-sale rule, and that a tax result should not decide a sale that the investment reasons do not support.

Stage Four: Know Where Average Cost Applies

Average cost combines all your purchases into a single per-share basis, which is then applied to every share you sell. It is common with mutual funds, where an investor who reinvests distributions over many years would otherwise track a long list of lots.

The method is available for mutual fund shares and certain other pooled investments, but generally not for individual stocks. Once you use average cost for a fund, there are rules about changing it: the choice can apply to that account and fund, and a switch can require notice to the broker and applies only to shares acquired afterward in some cases. Because those rules are technical, confirm the details with your broker or a tax professional.

The effect of average cost is to smooth things out. It rarely produces the lowest possible gain on a given sale, and it rarely produces the highest. It trades control for convenience.

Stage Five: Pick, Record and Review

With the options in view, a practical process is easier to follow. Decide which accounts and holdings will use which method, set your preference with the broker, and confirm that it appears on your statements. Before large sales, review your lots and see what each method would produce. After each year, compare the gains your broker reported with your own records.

• Find out your broker's default method for each account.
• List your lots by purchase date and cost.
• Check whether the holding period would turn long-term soon.
• Record the method you chose and the date you chose it.

The aim is not to minimize every gain at any cost. It is to know what you are doing, so that the number on your tax form is the one you meant to produce. A qualified tax professional can help with the larger decisions.

An Illustrative Sale (Hypothetical)

This walk-through is an illustration of a routine, not a recommendation or a result, and it uses no figures or securities.

Imagine a physician who built a position through three purchases in different years and now wants to sell about a third of it. Before placing the order, she pulls up the lot detail from her broker. She notes the purchase dates, the cost of each lot and the current value. She asks what the gain would be if the oldest lot were sold, and what it would be if the most recently bought lot were sold, and she sees that the two results are different in size and in holding period. She considers whether her reasons for selling are about the investment or the tax, and she answers the investment question first. She then specifies the lots with her broker before the trade, records her choice and sends the confirmation to her accountant.

Frequently Asked Questions

What is the difference between FIFO and specific lot identification?

FIFO sells your oldest shares first by default, while specific lot identification lets you choose which purchase lots are sold. Specific identification offers more control over the gain and the holding period, but it requires clear instructions to your broker.

What cost basis method does my broker use by default?

For most stock sales, the default is FIFO, and for mutual funds it is often average cost. Brokers differ, so look in your account settings or ask, because the default applies when you give no other instruction.

Can I change my cost basis method after I sell?

Generally no, because the method has to be set before or at the time of the trade settlement. After that, the sale is reported using the method in effect, so confirm your choice before you place the order.

Does cost basis matter in a retirement account?

Usually not for tax reporting, since gains inside most retirement accounts are not taxed each year. It matters in taxable accounts, where the gain or loss on each sale is reported.

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