Cost basis & taxes

What's cost basis?

Simply put, cost basis is the amount you paid—including brokerage fees, loads, and any other trading costs—to purchase an investment. This often means the price at the time of original purchase, although in some cases you'll have an adjusted cost basis.

Any time you sell an investment, you'll look at the difference between the current market value and your cost basis to determine whether you've had a gain or a loss on the sale. That's something to consider as you think about your overall tax strategy.

You'll also want to factor in the amount of time you've held an investment, since an asset you've held for over a year is considered a long-term investment and could be taxed at a lower rate than a short-term investment (something owned for less than 1 year).

Why it's important to report cost basis accurately

The IRS requires you to report capital gains and losses on your annual tax return when you sell or redeem shares of stocks, bonds, mutual funds, ETFs, and other investments.

Choosing the right method for calculating your cost basis will determine in part how much you'll pay in taxes for the current year, and how detailed your recordkeeping will need to be.

Find out which cost basis methods are available at Vanguard

Cost basis methods for calculating taxes

There are several methods for calculating the cost basis of an investment, and choosing the right one can significantly impact your tax liability on capital gains. These are the main methods of determining your tax cost basis:

1. Average cost (AvgCost). This method averages the cost of all shares you own, including reinvested dividends and capital gains distributions. This is the default method Vanguard uses for mutual funds, unless you choose a different method. Note that covered shares—which generally refers to stocks purchased after January 1, 2011, and mutual funds or ETFs purchased after January 1, 2012—will be used to calculate one average cost basis while noncovered shares (purchased before those dates) will be used to calculate a separate average cost basis for those shares.   
2. First in, first out (FIFO). This method assumes that the first shares you bought are the first shares you sold. It can result in higher capital gains if the earliest shares were purchased at a lower price. FIFO is the default cost basis method Vanguard uses for all investments other than mutual funds, unless you choose a different method.
3. Highest in, first out (HIFO). This method will automatically sell the shares purchased at the highest price first. It usually allows you to maximize losses and minimize gains with respect to your holdings, but it's important to note that HIFO doesn't consider holding period. So, it may sell shares with a short-term gain before selling shares with a long-term gain.
4. Minimum tax (MinTax). This method automatically selects the lots of securities you sell in an attempt to minimize the income tax you'll owe for the current year. It's available for mutual funds, ETFs, and stocks. Be aware that MinTax looks for the type of gain, not the amount of gain—so it'll prioritize long-term gain first (over short-term gain) but won't consider the size of the gain.  

When it comes to cost basis and taxes, each method has its own advantages and can yield different tax outcomes depending on the specific circumstances of your investments. It's important to consider your investment history and current market conditions when selecting a method to ensure the most tax-efficient outcome.

You can read more about cost basis methods available at Vanguard, and the pros and cons of each method. 

How to calculate average cost basis

The default treatment for mutual funds is the average cost method. It's an automated method, so you don't have to choose which shares to sell. Your gains or losses are spread evenly across all the shares you own.

Here's an example to show how the average cost method works: Let's say you purchased 100 shares of a stock at $50 each in January 2015, with a total commission charge of $10. Then you purchased another 100 shares at $80 per share in March 2017, with an additional $10 commission fee. You've now decided to sell 40 shares at the current market value of $100 each.

For your first batch (purchased in 2015), you paid $5,000 for the shares, plus $10 commission, so your cost basis was $50.10 per share. For the second batch (purchased in 2017) you paid $8,000 for the shares, plus $10 commission, making your cost basis on this batch $80.10 per share.

Using the average cost method, your cost per share would be the average of those 2 figures, which is $65.10. That means 40 shares would have cost you $2,604. Your gain—after the sale that netted you $4,000—would be $1,396.

What difference can cost basis make on your taxes?

To understand the difference cost basis can make on your taxes, we'll go back to an example used above. Imagine you bought 100 shares of a stock at $50 each in January 2015, with a total commission charge of $10. Then you purchased another 100 shares at $80 per share in March 2017, and paid an additional $10 commission. You've now decided to sell 40 shares at the current market value of $100 each.

1. We've already explain how using the average cost method would result in a calculated gain of $1,396.
2. If you use the MinTax method, you'd be selling from the higher-cost batch of shares purchased at $80.10/share, 40 of which cost you $3,204. Your gain would be calculated at $796.
3. If you choose the FIFO method, you'd be selling from the first batch of shares purchased at $50.10/share, 40 of which cost you $2,004. Your gain would be calculated at $1,996.

Note that in this example, if the date of the sale is before March 2018 (under one year), the MinTax method would result in a short-term capital gain, whereas the other two methods would incur a long-term capital gain.

As you can see, the cost basis method you choose will impact the gains you'll need to report on your taxes. You may offset capital gains with capital losses from other investments (subject to IRS limitations), which can reduce your tax liability.

Keep in mind that the best cost basis method for you may also depend on the type of transaction and your tax strategy. For example, if you're selling shares, you may want to target depreciated shares to minimize capital gains. But if you're gifting or making an in-kind transfer, you may want to take the opposite approach and target the shares that have appreciated the most.

Specific situations that can impact cost basis

The cost basis of an investment can be affected by several specific situations, and it's important to pay attention to these for tax purposes. Here are some examples:

Stock splits

Stock splits and reverse splits can change the number of shares you own and the per-share cost basis. For example, a 2-for-1 stock split doubles the number of shares but halves the cost basis per share. A stock spilt won't affect your overall cost basis, but it changes your per-share cost basis. 

Reinvested dividends and capital gains distributions

Some investors choose to have the dividends or capital gains distributions they receive from an investment automatically used to purchase additional shares of the same security. When the distribution is reinvested, it's added to your cost basis—so the number of shares you own increases, as does the cost basis for those shares.

It's important to keep track of this so you can accurately report your capital gains or losses on your tax return and avoid possible penalties. 

Gifted securities

Gifted securities are investments that are transferred from one person to another (or to a noncharitable entity) as a gift, rather than through a purchase or sale. The cost basis of gifted securities is usually the same as the donor's cost basis, unless the fair market value at the time of the gift is lower than the donor's cost basis.

When you receive gifted securities that have depreciated, you won't know the cost basis until you sell them. If you sell them for more than the donor's original basis, you'll use the original cost basis.

If you sell for less than the fair market value at the time of the gift, you'll use the fair market value as your cost basis. And if you sell for more than the fair market value at the time of the gift, but less than the original basis, you won't have a gain or a loss to report.

You can read more about gifting securities or other assets here.

Wash sales

A wash sale happens when you sell a stock or security at a loss and then buy the same or a substantially identical stock or security within 30 days before or after the sale. In this case, you're not allowed to claim the loss on your tax return for that year. The IRS implemented this rule to prevent investors from claiming a tax loss and then immediately repurchasing the same or similar security to benefit from the lower price.

In the case of a wash sale, your disallowed loss is added to the cost basis of the new shares you purchased. This adjustment can affect your future capital gains or losses when you eventually sell the new shares.

The wash sale rule applies across all your accounts, but Vanguard is only required to report wash sales of covered shares in the same account where the shares are identical (meaning they have the same CUSIP number). Keeping detailed records and being aware of the timing of your trades can help you manage your tax obligations effectively and avoid wash sales. 

For tax purposes, covered shares are those for which Vanguard is required to report cost basis information to both you and the IRS. For noncovered shares, Vanguard will only report cost basis information to you.

Speaking with a tax professional can provide further guidance.

How Vanguard reports cost basis

Vanguard provides detailed cost basis information to help you report your capital gains or losses on your tax forms. We issue a Form 1099-B for each sale of securities in your taxable accounts. It includes the cost basis for the sold shares, which is the original purchase price adjusted for any splits, and other transactions.

You can read an overview on how we report cost basis, including details on covered and noncovered shares.

Want to view or change your cost basis method?

1. Log in to your account at vanguard.com. Then, from All accounts, navigate to the Portfolio tab and select Cost basis from the dropdown.
2. Select the account and click View/Change cost basis method.
3. Select the holdings from the cost basis method page.