If you own mutual funds, you probably know that when you sell fund shares you incur a taxable gain or loss. The amount of 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 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 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.

You are allowed to choose other methods, such as: first in, first out; average cost (single-category and double-category); and specific identification.

First In, First Out
Under this method—also known as FIFO—the first shares bought are considered the first shares sold. Unless you specify that you are using another method, the Internal Revenue Service will assume that you are using FIFO.

Here’s an 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 another 100 shares of TopLine, for a total purchase price of $1,500. Last year, you sold 50 of your TopLine shares for $600. On your income-tax return, you report a capital gain of $100 ($600 minus $500).

Using the FIFO method, it’s 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 50 shares sold is actually $500.

Average Cost
This approach lets you calculate an average cost for each share by adding up the total cost of all the shares you own in a particular mutual fund, then divide 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 group all shares together, add up the cost and divide by the number of shares. However, it is deemed that the first shares that you sell are those you’ve held the longest.

- The double-category method lets you 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. You may specify whether you are redeeming long-term or short-term shares. If you do not specify the category, you will be deemed to have sold from the long-term category first.

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

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’ve 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 shares with the highest purchase prices and indicate that you’re selling those. This strategy gives you the smallest capital gains and may save you significantly on taxes.

You must indicate to your financial advisor, or to the mutual fund itself, the specific shares that you’re selling. 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 your fund shares’ basis.

1.  Dividend and capital-gains distributions that are automatically reinvested are taxable to you as ordinary income or capital gains, even though you don’t actually receive them in the current year. That’s the bad news. The good news is that these reinvested amounts increase your cost basis.

2. Amounts that you pay as fees or commissions when you purchase shares are included in the basis. For example, if you buy 100 shares of HighFlyer mutual funds for $10 a 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.)

While none of this is too tricky, it does require attention to detail and proper recordkeeping. Don’t hesitate to consult with your financial advisor if you need help. 

This column is produced by Financial Planning Associates, and is provided by R.Hutton Cobb, a Wachovia Securities financial advisor in Greenville, N.C.