Imagine you’ve bought a shiny new car. It has dozens of beautiful chrome knobs and levers. There are sturdy paddles behind the steering wheel that make a satisfying click sound when depressed. The center console sports a big red button, shined to a gloss, seductively flashing the word “Push”. Now imagine that I own this car, but that the only parts of it I’ve touched are the steering wheel and the gas and brake pedals. This about sums up my experience with my investment websites, where about the only button I’ve pressed is “Buy”.
However, to properly harvest investment losses as I outlined in my previous post, we’re going to have to dust off the manual and learn a new trick or two. Specifically, we need to know two things: our investment’s cost basis, and how our investment company determines that cost basis.
A cost basis is the price at which a stock or mutual fund was purchased. If you buy a single share of Microsoft stock for $50 per share, $50 is the cost basis. If, a week later, you sell this share for $51, you have just made 1$, which may be subject to taxation based on your tax bracket. If, instead, you sell the stock for $49, you have just generated a loss of $1, which you can deduct on your federal income taxes.
Simple, right? In theory, it is. But the reality is that most investors purchase investments at regular intervals over the course of years. These funds were purchased at dozens of different prices, meaning the cost basis is all over the place. When we sell a few shares, how do we know which shares we’re actually selling? How do we know our cost basis?
There are many different ways to determine cost basis, which I’ll outline below. Most investment companies will default to one of these options, but in most cases you can change those defaults.
Average Cost Basis – When you sell shares of a fund under this method, the cost basis is calculated as the average of all the cost bases of all the shares you own of that fund. If you bought 10 shares at $50, 10 at $75, and 10 at $100, they would all sell at a cost basis of $75. This is the simplest method, but not the best for tax loss harvesting, because the averaging smooths out the very dip in price you are trying to capture your losses on. Many investment firms default to this method.
FIFO Cost Basis – FIFO stands for First-In-First-Out. When you sell shares under this method, you are selling the first shares you ever purchased. Another way to say it is that you are selling your oldest shares. This may work in limited cases, but in general this is not optimal either, because historically the stock market has gone up. Meaning that over a long investment horizon your oldest shares should generally have your lowest cost basis. These would give you the least loss (if any) to deduct.
LIFO Cost Basis – LIFO Stands for Last In First Out. Think of your shares like a stack of plates where you both place and remove shares from the top of the pile. Since this does not specify based on price, it is a crapshoot and I don’t recommend it for tax loss harvesting.
High Cost – In this method, your highest value shares are sold first. Picture your shares lined up by order of height. As you sell them, the tallest ones walk out of the room first. This is a good option for tax loss harvesting, since it will maximize your cost basis.
Low Cost – The opposite of High Cost, Low Cost sells your lowest basis shares first. This is all wrong for tax loss harvesting, because it guarantees the smallest possible loss.
Specific Shares Option – This is the best method to use, but also requires the most work. Specific Shares allows you to peruse your history of stock sales and specify exactly which shares you’d like to sell. Using this method, you’ll know exactly how much loss you’ve incurred. But if the tedium of pouring over shares gives you pause, I would suggest staying with the High Cost share option. It’s not important that you do this perfectly; it’s more important that you do it, period.
Every investment firm is different, so you’ll have to research your options, get in touch with them and learn how to change your cost basis calculation. Every one I’ve ever used has been happy to explain the sales process to me, and some have a convenient ‘online chat’ option. Now that you understand your options, get out there and lose some money!