When selling shares from a mutual fund, how do I know which shares have been sold, and how do I determine the cost of the shares in order to compute my tax on the sale?
It's up to you, which shares you sell from a fund, and you have control over the costing method as well.
If you sell all the shares you own in a mutual fund, figuring the cost is pretty easy. Your cost is the amounts you paid for all the shares. The only catch is that you must include the value of any reinvested dividends along with the amounts you actually paid for the shares. So if you bought 1,000 shares at $1.00 per share ($1,000) and 1,000 shares at $1.20 per share ($1,200), and your dividends that were reinvested paid for an additional 10 shares at $1.10 per share ($11.00), your total cost of all the shares sold is $2,211.
The process of determining your cost becomes a little more complicated if you don't sell all the shares in the fund. You have three choices for valuing the shares you sell:
Average the cost of the shares. This is the easiest method, take an average of all the shares in the fund at the time you make the sale, and use the average price as the sales price for the shares you sell. In the above example, the total of 2,010 shares cost $2,211, so the average for one share is $2,211 divided by 2,010, or $1.10. If you sell 500 shares, your cost of the shares sold is 500 times $1.10, or $550. Many mutual fund statements now contain information about the average cost of the shares, so you don't even have to perform this simple calculation yourself.
Use the First-In, First-Out method. Accountants like to call this method FIFO, which is a little reminiscent of the language of Jack and the Beanstalk. The idea behind this method is that the first shares you bought (the first "in") are the first shares you sell (the first "out"). In the above example, the first shares you bought were the $1.00 shares, so your sale of 500 shares has a cost of $500.
Specifically identify the shares you sell. They're your shares, you can sell whichever shares you want to, you just have to let someone know. So, when you contact your broker to make the sale, or when you get in touch with the mutual fund and request a sale of shares, let it be known which shares you want to sell. Indicate the date on which you purchased the shares you are selling. It's best to make this kind of a sale with a written request, providing the broker or the fund manager with one copy, and keeping a copy for your tax records. This method gives you the most control over how much gain or loss you are going to report on the sale.
Although averaging your price per share is usually the easiest method of costing your shares, it may not give you the best results from a tax standpoint. Consider the tax effects of each method in relation to the rest of your tax return. You may have capital losses from other sales that would make an offsetting gain from the mutual fund attractive. For example, the IRS limits the amount of capital loss you can deduct each year to $3,000, but that $3,000 is calculated after capital losses have been offset with capital gains. A gain from the mutual fund may have the result of entitling you to take a larger deduction for losses.
Note that if you use the average method for valuing your shares, you must continue using that method for all other sales of shares in the fund (but this choice doesn't affect the way you value shares in other funds). There is also a choice you can make when averaging the cost of your shares. You can choose to average the cost of all shares in the fund, or you can separate the shares into a long-term group and a short-term group, and specify to the broker or fund manager from which group you are selling. The latter method takes more time and the calculations change as the status of shares changes from short-term to long-term.
No matter which method of valuation you use, be sure to keep good records. When you sell a portion of the shares in a mutual fund, it's very important to keep track of the cost you reported on your tax return and the method you used to calculate that cost. Not only do you need to keep those records as support for the numbers on your tax return, you will need to refer back to the sales records from earlier years when you get ready to determine the cost of the remaining shares in the fund.