3.5.5.6. Calculating Capital Gains on Shares Sold at a Profit
When an investor sells shares, the investor must calculate the amount of the gain for tax purposes. The amount of the gain is the difference between the price at which the shares were sold and the cost basis of the shares. The cost basis is the amount that was spent to make an investment, including commissions and fees. Finding the cost basis can be complicated because mutual fund shares are often bought at different times and at different prices. For the exam, you may need to know three of the methods that the IRS accepts for calculating cost basis.
1. First in, first out (FIFO). The shares bought earliest are assumed to be the shares that are sold. This is the most conservative method and usually results in the highest capital gain because shares usually appreciate over time. If the investor doesn’t specify which method she is using, the IRS will assume it is the FIFO method.
2. Average cost. The average cost is calculated over all the shares held in the account. Once this method is chosen for a fund, the investor must stick to this method, unless she gets permission from the IRS to change. Often the investor’s brokerage firm will calculate the average cost for the investor.
3. Specific identification. The investor chooses the specific shares that are to be sold and identifies the c