What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.

Understanding the Average Cost Basis Method

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. For example, an investor that has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 / 500).

Types of Cost Basis Methods

Although many brokerage firms default to the average cost basis method for mutual funds, there are other methods available.

FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first when calculating gains and losses. For example, let’s say an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. If the investor sold 30 shares, the 20 in January must be used, and the remaining ten shares sold would come from the second lot purchased in April. Since both the January and April purchases would have been executed at different prices, the tax gain or loss would be impacted by the initial purchase prices in each period.

Also, if an investor has had an investment for more than one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in less than one year. As a result, the FIFO method would result in lower taxes paid if the investor had sold positions that were more than a year old.

LIFO

The last in first out (LIFO) method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased, which might be at a lower price relative to the current market price.

High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. In other words, the shares that were the most expensive to buy get sold first. A high-cost method is designed to provide investors with the lowest capital gains tax owed. For example, an investor might have a large gain from an investment, but doesn’t want to realize that gain yet, but needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss, from a tax standpoint, to offset other gains or income.

Conversely, the low-cost method allows investors to sell the lowest-priced shares first. In other words, the cheapest shares you purchased get sold first. The low-cost method might be chosen if an investor wants to realize a capital gain on an investment.

Choosing a Cost-Basis Method

Once a cost basis method has been chosen for a specific mutual fund, it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Please note that the cost basis only becomes important if the holdings are in a taxable account, and the investor is considering a partial sale of the holdings.

Specific Identification Method

The specific identification method (also known as specific share identification) allows the investor to choose which shares are sold in order to optimize the tax treatment. For example, let’s say an investor purchases 20 shares in January and 20 shares in February. If the investor later sells 10 shares, they can choose to sell 5 shares from the January lot and 5 shares from the February lot.

Example of Cost Basis Comparisons

Cost basis comparisons can be an important consideration. Let’s say that an investor made the following consecutive fund purchases in a taxable account:

• 1,000 shares at $30 for a total of $30,000
• 1,000 shares at $10 for a total of $10,000
• 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000, and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

Suppose the investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

• ($25 – $14.86) x 1,000 shares = $10,140.

Results can vary depending on the cost-basis method chosen for tax purposes:

• First in first out: ($25 – $30) x 1,000 shares = – $5,000
• Last in first out: ($25 – $8) x 1,000 = $17,000
• High cost: ($25 – $30) x 1,000 shares = – $5,000
• Low cost: ($25 – $8) x 1,000 = $17,000

From strictly a tax standpoint, the investor would be better off selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. However, with the average cost basis method, the investor must pay a capital gains tax on the $10,140 in earnings.

Of course, if the investor sold the 1,000 shares using the FIFO method, there’s no guarantee that when the remaining shares are sold that $25 will be the selling price. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain would have been lost. As a result, investors must weigh the choice as to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment.

What Is an Alternative Depreciation System (ADS)?

An alternative depreciation system (ADS) is one of the methods the Internal Revenue Service (IRS) requires taxpayers to use to determine the depreciation allowed on business assets. An ADS has a depreciation schedule with a longer recovery period that generally better mirrors the asset’s income streams than declining balance depreciation. If the taxpayer elects to use an alternative depreciation system, they must apply it to all property of the same class placed in service during the same year.

Understanding when to use ADS is important for business owners because accurately calculating depreciation expenses can help lower business taxes. However, the IRS rules regarding ADS can be complex. For this reason, many business owners opt to hire a tax professional to ensure they take as much depreciation expense as the IRS allows.

Understanding Alternative Depreciation System (ADS)

Depreciation is an accounting method that allows businesses to spread out the cost of a physical asset over a specified number of years, which is known as the useful life of the asset. The useful life of an asset is an estimate of the number of years a company will use that asset to help generate revenue. The IRS allows businesses to depreciate many kinds of business assets, including computers and peripherals; office furniture, fixtures, and equipment; automobiles; and manufacturing equipment.

Taxpayers who elect to use the alternative depreciation system feel that the alternative schedule will allow for a better match of depreciation deductions against income than the recovery period under the general depreciation system. While the ADS method extends the number of years an asset can be depreciated, it also decreases the annual depreciation cost. The depreciation amount is set at an equal amount each year with the exception of the first and last years, which are generally lower because they do not include a full twelve months.

Alternative Depreciation System (ADS) vs. General Depreciation System (GDS)

For property placed in service after 1986, the IRS requires that taxpayers use the Modified Accelerated Cost Recovery System (MACRS) to depreciate property. There are two methods that fall under the MACRS: the general depreciation system (GDS) and the alternative depreciation system (ADS).

The alternative depreciation system offers depreciation over a longer period of time than the general depreciation system, which is a declining balance method. The general depreciation system is often used by companies to depreciate assets that tend to become obsolete quickly and are replaced with newer versions on a fairly frequent basis. Computers and phone equipment are examples of this.

The general depreciation system allows companies to accelerate the asset’s depreciation rate by recording a larger depreciation amount during the early years of an asset’s useful life and smaller amounts in later years. The general depreciation system is more commonly used than the alternative depreciation system.

Special Considerations

The tax implications of calculating depreciation can affect a company’s profitability. For this reason, business owners need to carefully consider the pros and cons of ADS versus GDS. Since the alternative depreciation system offers depreciation over a longer course of time, the yearly deductions for depreciation are smaller than with the other method. Taxpayers who choose the alternative depreciation system schedule must use this schedule for all property of the same class that was placed in service during the taxable year.

However, taxpayers may elect the alternative depreciation system schedule for real estate on a property-by-property basis. The alternative depreciation system recovery schedule is listed in IRS Publication 946.

What Is the Annualized Income Installment Method?

Taxpayers who are self-employed typically pay quarterly installments of their estimated tax in four even amounts as figured by the regular installment method. Additionally, taxpayers should pay estimated taxes if they receive substantial dividends, interest, alimony, or other forms of income that are not subject to income tax withholding.

When a taxpayer has a fluctuating income, it often causes them to underpay on one or more of the quarterly estimates leading to underpayment penalties. The annualized income installment method calculates the taxpayer’s estimated tax installment payments and helps to decrease underpayment and corresponding underpayment penalties related to fluctuating income. Through the use of the annualized income installment method, taxpayers may estimate their taxes based on known information from the beginning of the tax year through the end of the period paid.

How the Annualized Income Installment Method Works

The purpose of the regular installment method is to figure in quarterly tax installments. It divides the annual estimated tax into four equal segments. The resulting payments are appropriate for the quarterly estimated taxes of taxpayers with a steady income, but this does not work as well for taxpayers whose income fluctuates. Some taxpayers may have a hard time finding the cash to pay estimated taxes in slower months.

Consider, for example, taxpayers Jane and John. Each of them owes $100,000 in annual estimated tax. Jane pays her estimated payments in four $25,000 installments per the regular installment method. She evenly earned her income, 25% each quarter, so the quarterly portions paid her estimated tax in full and on time. 

John’s earnings were uneven, with each tax quarter at 0%, 20%, 30%, and 50%, respectively. John may have a difficult time coming up with the cash necessary to make his first and second quarter estimated tax payments when his earnings are low. Using the regular installment method, if John were to pay less estimated tax in the first two quarters and more in the second two quarters, he would owe an underpayment penalty for the first two quarters.

The annualized income installment method allows John to refigure his installments, so they correlate to his income as he earns it. It does so by annualizing John’s installments over four overlapping periods. Each period begins on Jan. 1. The first period ends on March 31, the second ends on May 31, the third on Aug. 31, and the fourth period ends on Dec. 31. Each period includes all the previous periods, with the final period encompassing the entire year. It allows John to estimate his tax payments based on his income to that point in the year.

In this example, we know the exact percentage of John’s annual earnings from each tax quarter. John pays $0 in March, $20,000 in May, $30,000 in August, and $50,000 in December. John now has four installments of different amounts that, when added together, equal his full annual estimated tax of $100,000. John’s refigured installments are now paid on time, his underpayment penalties abated.

IRS Publication 505 has forms, schedules, and worksheets that guide taxpayers desiring to refigure their installments using the annualized income installment method. However, figuring installments this way is complicated and best done on an IRS worksheet by your favorite tax professional.

What Is the Additional Child Tax Credit?

The additional child tax credit was the refundable portion of the child tax credit. It could be claimed by families who owed the IRS less than their qualified child tax credit amount. Since the child tax credit was non-refundable, the additional child tax credit refunded the unused portion of the child tax credit to the taxpayer. This provision was eliminated from 2018 to 2025 by the Tax Cuts and Jobs Act (TCJA).

However, under the TCJA, the child tax credit includes some provisions for refundable credits. In addition, on March 11, 2021, President Biden’s American Rescue Plan was voted into law and made child tax credits fully refundable in 2021.

Understanding the Additional Child Tax Credit

A tax credit is a benefit given to eligible taxpayers to help reduce their tax liabilities. If Susan’s tax bill is $5,550 but she qualifies for a $2,500 tax credit, she will only have to pay $3,050. Some tax credits are refundable, meaning that if the tax credit amounts to more than what is owed as tax, the individual will receive a refund. If Susan’s tax credit is actually $6,050 and is refundable, she will be given a check for $6,050 – $5,550 = $500.

Depending on what tax group a taxpayer falls in, they may be eligible to claim a tax credit. For example, taxpayers with children may qualify for the child tax credit which helps to offset the costs of raising kids.

For the 2022 through 2025 tax year, the child tax credit allows eligible tax filers to reduce their tax liability by up to $2,000 per child. To be eligible for the child tax credit, the child or dependent must:

• Be 16 years or younger by the end of the tax year
• Be a U.S. citizen, national, or resident alien
• Have lived with the taxpayer for more than half of the tax year
• Be claimed as a dependent on the federal tax return
• Not have provided more than half of their own financial support
• Have a Social Security number

Child Tax Credit vs. Additional Child Tax Credit

Previously, the child tax credit was non-refundable, which means the credit could reduce a taxpayer’s bill to zero, but any excess from the credit would not be refunded. Families who wanted to keep the unused portion of the child tax credit could go the route of another available tax credit called the additional child tax credit.

This credit was a refundable tax credit that families could qualify for if they already qualified for the non-refundable child tax credit. The additional child tax credit was ideal for families who owed less than the child tax credit and wanted to receive a refund for the surplus credit.

While the additional child tax credit was eliminated in 2018 under the Tax Cuts and Jobs Act (TCJA), up to $1,400 of the $2,000 child tax credit can be refundable for each qualifying child if certain conditions are met. For example, a taxpayer needs to earn more than $2,500 for the tax year to qualify for any refund. To claim a refund, filers must complete Schedule 8812.

The American Rescue Plan created major changes to the child tax credit for 2021. The maximum credit rose to $3,000 (children up to 17) or $3,600 (children younger than six). Qualifying families started receiving monthly checks (half of the full credit) in July 2021. The credit also became fully refundable in 2021, and families may claim the second half of the credit on their 2021 tax return. This child-related tax benefit begins to phase out for individual filers with children who earn more than $75,000 and joint filers earning more than $150,000.

Example of the Additional Child Tax Credit

Before the TCJA, the IRS allowed families with an annual income of more than $3,000 to claim a refund using the additional child tax credit. The tax credit depended on how much the taxpayer earned and was calculated by taking 15% of the taxpayer’s taxable earned income over $3,000 up to the maximum amount of the credit, which was then $1,000 per child. The total amount above $3,000 (subject to annual adjustments for inflation) was refundable.

For example, a taxpayer with two dependents qualifies for the child tax credit. Their earned income is $28,000, which means income over $3,000 is $25,000. Since 15% x $25,000 = $3,750 is greater than the maximum credit of $2,000 for two kids, they would have received the full portion of any unused credit.

So if the taxpayer received an $800 child tax credit, they would be refunded a $1,200 Additional child tax credit. However, if the taxable earned income was $12,000 instead, 15% of this amount over $3,000 is 15% x $9,000 = $1,350. Because the refundable portion of the credit cannot exceed 15% of earned income above $3,000, the taxpayer would receive a maximum refund of $1,350, not $2,000.

Taxpayers who were residents of Puerto Rico with income below $3,000 were eligible if they had at least three qualifying dependents and paid Social Security tax in excess of the amount of their earned-income credit for the year.