Changing Cost Basis on Mutual Funds

[jswans232]

I'm trying to determine if I am permitted by the IRS to change from Average to Specific ID cost basis for one of my mutual funds.  I did sell some shares of the fund in 2008 using the Average method.  Can I now change to the Specific ID cost basis when selling any shares acquired after the sale in 2008?  Some documents say once you sell shares using the Average method you can NEVER switch to any other method while other documents say you can switch to Specific ID but it only applies to shares acquired after your last sale under the Average method, while shares acquired prior to the sale must still use the Average method.

[Mike9241]

different rules for covered and non-covered shares. in any case you'll have to contact the mutual fund so they can change the cost method used for reporting to the IRS if they allow it

Noncovered shares
For noncovered shares (generally shares acquired before 2012). You can use the average basis method beginning with any year you choose, even if you used the separate lot method for sales from this account in earlier years. Once you do this, there’s no going back: the average basis method will continue to apply to all future sales of noncovered shares of this mutual fund from this account.

Covered shares

Consequences of changing from averaging

The tax regulations now contain this helpful rule: “A taxpayer may change basis determination methods from the average basis method to another method prospectively at any time.” You do this by notifying the broker or mutual fund company “in writing by any reasonable means,” which would include completing an online form if the company provides one for this purpose.

A prospective change from the average basis method doesn’t restore the original basis of lots you own at the time of the change. These lots will continue to have the same averaged basis they had at the time you made the change. Any lots you acquire in the future won’t be averaged with these lots, however.

Example: Using the average basis method, you bought 100 shares at $10 and another 100 shares at $20. Then you changed from the average basis method prospectively and subsequently bought another 100 shares at $30. The result: you hold two lots with basis of $15 per share and another with basis of $30 per share.

Changing from the average basis method lets you acquire additional shares with a cost basis that differs from your existing shares. It also permits you to use share identification, so you can sell newer shares before older ones in situations where that would produce a tax benefit. Share identification isn’t permitted while using the average basis method.

Changing retroactively for covered shares

Consequences of revoking averaging

Subject to limitations, it may be possible to undo the average basis method retroactively, restoring lots to their original cost basis. The tax regulations provide this result when you revoke an election to use the average basis method. In Notice 2011-56, the IRS provided similar relief for situations where the average basis method was applied because it’s the default method of the broker or mutual fund company rather than because the investor elected that method.

Example: In the example above, if you revoked an averaging election instead of changing from it prospectively, the first two lots would revert back to their original bases of $10 and $20.

Limitations. You aren’t allowed to change your method retroactively after you’ve sold any shares while the average basis method was in effect. In this situation you can change to the separate lot method prospectively, but it won’t be possible to restore the original cost basis of lots you held while using the average basis method.

In addition, you can’t make this retroactive change after the time limit set by your broker or mutual fund company expires. They’re required to allow at least a year, but permitted to allow a longer period, and many mutual fund companies have indicated they’ll be lenient, perhaps even permitting these changes for an indefinite period. Be aware, though, that the first sale of shares terminates your ability to make this retroactive change, even if it occurs within the first year.

If you’re using the average basis method due to having elected it (by notifying the broker or mutual fund company), the minimum one-year period is measured from the date you made the election. If you’re using it automatically due to the default method chosen by the company, the one-year period runs from the date they notified you of their default method.

[jswans232]

Thank you for responding; great info.  Based on this info it sounds like I can do what I was hoping which is to draw down this account slowly in a tax friendly way (I am an early retiree and need the money for living expenses).  That is, my account is currently set to Specific ID (I changed that a year ago).  I am going to sell off all of the specific lots acquired since 1/1/2012 (covered shares) and report the actual cost basis per lot on my taxes.  Once they are gone, I will switch back to Average for the remaining shares acquired prior to 1/1/2012 (uncovered shares) and report the average cost basis on my taxes as I sell them.  Although I’m not sure I need to make the change since all shares acquired before 1/1/2012 are currently showing as one large lot with what I assume is the Average cost basis.  This mutual fund account is with Vanguard.  Does this plan keep me in good graces with the IRS?

[fanfare]

If Vanguard will take off average cost basis, and then put it back later (years from now), then you don't have to worry about IRS as long as you report what is shown on your 1099-B from Vanguard.

I hope you have properly verified that these changes will be giving you the effects you want.