Most investors know what they paid for their first purchase of a stock. Far fewer know what number their broker will report when they sell, and the difference can move a tax bill by hundreds or thousands of dollars.
What Cost Basis Is
Cost basis is what you paid for your shares, including commissions and fees. When you sell, your taxable gain or loss is simply:
Sale proceeds - cost basis = capital gain (or loss)
If you bought 10 shares at $50 and paid a $0 commission, your basis is $500. Sell them at $80 for $800 and your gain is $300. That part is easy. The complexity starts when you bought the same stock more than once.
Why Multiple Purchases Complicate Things
Each purchase creates a tax lot: a batch of shares with its own date and price. Say you built a position in three steps:
| Lot | Date | Shares | Price | Cost |
|---|---|---|---|---|
| A | January | 10 | $50 | $500 |
| B | April | 10 | $70 | $700 |
| C | August | 10 | $90 | $900 |
You now hold 30 shares with a total cost of $2,100. Suppose you sell 10 shares at $100 ($1,000 proceeds). Which 10 shares did you sell? The answer depends on the method used.
The Three Main Methods
1. FIFO (First In, First Out)
FIFO assumes you sell the oldest shares first. It is the default at most US brokers for individual stocks.
- Shares sold: Lot A (basis $500)
- Gain: $1,000 - $500 = $500
In a rising market, FIFO sells your lowest-cost shares first, which produces the largest gain. The upside: oldest lots are more likely to qualify for long-term capital gains rates, which are generally lower than short-term rates.
2. Average Cost
Average cost blends all lots: $2,100 / 30 shares = $70 per share.
- Shares sold: 10 at an assumed $70 basis = $700
- Gain: $1,000 - $700 = $300
Average cost is the standard for mutual funds at many brokers and is simple to track, but it removes your ability to choose lots. Rules differ by account and security type, so confirm how your broker applies it.
3. Specific Lot Identification
You pick the lots. To minimize this year's gain, you sell the highest-cost lot.
- Shares sold: Lot C (basis $900)
- Gain: $1,000 - $900 = $100
| Method | Basis used | Taxable gain on a $1,000 sale |
|---|---|---|
| FIFO | $500 | $500 |
| Average cost | $700 | $300 |
| Specific lot (highest cost) | $900 | $100 |
Same trade, same shares, three different gains. The total gain over time is not erased, because the shares you did not sell keep their own basis, but you control when the tax is paid and whether it is short-term or long-term. See Capital Gains Tax for Investors for how the holding period changes the rate.
Practical note: specific lot selection usually has to be chosen with your broker at or before the time of sale. Check your account's default method and change it if it does not suit you. This is general education, not tax advice; a tax professional can confirm what applies to you.
What Adjusts Your Cost Basis
- Stock splits change your per-share basis but not your total. A 2-for-1 split turns 10 shares at $50 into 20 shares at $25.
- Reinvested dividends are new purchases, and each one adds to your basis. Forgetting this is a common way to overpay tax by counting the same money twice.
- Return-of-capital distributions reduce your basis.
- Wash sales can defer a loss by adding it to the basis of the replacement shares. See the wash sale rule explained.
- Gifted and inherited shares follow different basis rules than shares you bought.
Cost Basis Is Also a Risk Number
Tax aside, your average cost is the most emotionally important price on your chart: it is your breakeven. Investors tend to anchor on it, hold losers hoping to "get back to even," and sell winners too early to lock in a gain.
Turning it into a rule helps:
- Compute your average cost (total dollars paid, including fees, divided by shares).
- Set a breakeven alert at that price so you know when a losing position recovers, without checking every day.
- Set a downside alert at a level where your thesis is broken, for example a set percentage below your average cost. It pairs well with a stop-loss plan; see Stop-Loss Orders Explained.
- Set a profit alert at your target so a rally prompts a decision instead of a surprise.
Setting These Alerts in Stock Alarm
In Stock Alarm you can create a price alert for any symbol in a few taps: pick the ticker, choose "price rises above" or "price falls below," and enter your number. Use your average cost for breakeven, and levels above and below it for target and risk. The step-by-step is in How to Set Stock Price Alerts. You will be notified when the price crosses, so you can review the position (and the lot you would sell) with a clear head.
Common Mistakes
- Not knowing your broker's default method. FIFO is often the default, which may not be what you want.
- Ignoring fees when computing your breakeven.
- Double-counting reinvested dividends.
- Averaging down without tracking the new blended cost. Your breakeven moves every time you buy. See Dollar-Cost Averaging for how repeated buys change your average.
- Changing methods after the sale. Once a trade settles, the lot choice is generally final.
