Stanley - Determining cost-basis of mutual funds shares

If you own mutual funds, you probably know that when you dispose of fund shares you incur a taxable gain or loss. The amount of the gain or loss is measured by the difference between your cost basis and the value of the shares sold.

That sounds straightforward enough, but calculating the capital gain or loss on shares you sell can be a little tricky, when you sell only some of your shares. Although reports from your funds may include a statement of gain or loss, these reports are provided as a convenience and usually rely on what is known as the "average cost method, single category rule."

However, this method may not be the most advantageous to you and you are allowed to choose one of several other methods.

The following methods are allowed:

-- First-in, first-out (FIFO)

-- Average cost (single category and double category)

-- Specific identification

First-in, first-out (FIFO)

Under this method, the first shares bought are considered the first shares sold. Unless you specify that you are using one of the other methods, the IRS will assume you are using FIFO.

Example: In 1992, you purchased 100 shares of TopLine Fund at $10 per share for a total purchase price of $1,000. Your cost basis for each share is $10 -- what you paid for the shares. In 1999, you purchased an additional 100 shares of TopLine, for a total purchase price of $1,500. Your cost basis for this purchase is $15 per share.

In 2002, you sell 50 of your TopLine shares for $600, or $12 per share. On this year's income tax return, you would report a capital gain of $100. Using the FIFO method, it is assumed that you sold 50 of the first TopLine fund shares that you purchased. With a cost basis of $10 per share, the cost basis of the 50 shares sold is $500. Subtracting the cost basis from the value of sale of the shares in 2002 gives you a capital gain of $100 ($600-$500).

Average cost

This approach allows you to calculate an average cost for each share by adding up the total cost of all the shares you own in a particular mutual fund and dividing by the number of shares. If you elect to take an average cost approach, you must then choose whether to use a single-category method or a double-category method.

-- With the single-category method, you simply group all shares together, add up the cost, and divide by the number of shares. Under this method, you are deemed to have sold first the shares you have held the longest.

-- The double-category method enables you to separate short-term and long-term shares. Shares held for one year or less are short-term; shares held for more than one year are long-term. You average the cost of shares in each category separately. In this way, you may specify whether you are redeeming long-term or short-term shares. If you do not specify which category shares are sold from you will be deemed to have sold from the long-term category first.

The double-category method can work in your favor, particularly where you are looking to offset long-term gains in one mutual fund with long-term losses from another fund. Categorizing the gains and losses by holding period makes it easier to identify which fund shares to sell and when to sell.

Keep in mind that once you elect to use either average cost method, you must continue to use it for all transactions in that fund unless you receive IRS approval to change your method.

Specific identification

Under this method, you specify the individual shares that are sold. If you have kept track of the purchase prices and dates of all your fund shares, including shares purchased with reinvested distributions, you will be able to identify those shares with the highest purchase prices and indicate that they are the shares you are selling. This strategy gives you the smallest capital gain and may save you a significant amount on taxes.

To take advantage of this method you must indicate to your broker or to the mutual fund itself the particular shares you are selling at the time of the sale or exchange. The IRS also requires that you receive written confirmation of your instructions.

Additional considerations

Whichever method you use, two other considerations are important in determining basis of your fund shares.

First, dividend and capital gain distributions that are automatically reinvested are taxable to you as either ordinary income or capital gains even though you don't actually receive them. That's the bad news. The good news is that that these reinvested amounts increase you cost basis.

Secondly, amounts you pay as fees or commissions at the time of purchase are included in the basis. For example, if you purchase 100 shares of HighFlyer mutual fund for $10 per share and pay an up-front commission of 2 percent, or $20, your cost basis for each share is $10.20 ($1,020 divided by 100).

None of this is rocket science. It just requires a little attention to detail and good record-keeping. If you have questions, your financial advisers should be able to help you find the answers.

Sharon Stanley is a representative of The Prudential Insurance Co. of America in Cape Girardeau. (334-2603 )