Every time a dividend is reinvested in a mutual fund, you’ve just paid more for the investment.  This is because you are income taxed on that dividend income, and you have chosen to buy more of that investment with that income.  We’re talking about mutual funds OUTSIDE of any retirement accounts here.

To determine your cost basis of mutual funds that you sell, you need to add up your original investment (if buying through a brokerage firm, this will be the “BOT” statement) plus all of the dividends reinvested.  For this reason, you need to keep every year end mutual fund statement which details all of the transactions throughout each year, in order to prove your cost basis when you sell. 

Sometimes you may sell only a part of your mutual fund investment.  This is where computer spreadsheets come in handy to keep track of the AVERAGE cost per share which you may use in determining your cost basis.  Or, you can keep track of the specific shares sold, using the cost basis of the first shares purchased as the first shares sold. 

Many mutual fund companies are keeping track of your cost basis information, and these calculations are usually accurate.  I have found inaccuracies, though, which do not include all the fees or commissions paid, as included in the cost basis.  The amounts are usually minor.

When you sell mutual fund shares, you will receive a 1099-B showing the gross proceeds being reported as income to the IRS, and you will need to report your cost basis against that income on the Schedule D of your personal income tax return.

When you “exchange” one mutual fund for another, you are effectively selling shares in one fund, and purchasing them in another.  You will receive a 1099-B showing that sale being reported to the IRS.  This surprises many people because they didn’t realize they were “selling” because the money is still invested.

We have another year before the IRS requires brokerage firms to report your cost basis when you sell stock. 

Update March 2011:  Brokers are NOT required to report basis for any securities you’ve acquired before 2011.

In the meantime, we haven’t found too many people who understand the term “cost basis”. 

If you receive a Form 1099-B in January for the year before, it means you’ve sold an investment through a brokerage firm. 

The total sale price of the investment is reported to the IRS on Form 1099-B.

You need to report the sale on your tax return on Schedule D.  You get to subtract your cost of the investment from the gross proceeds, to determine your gain or loss on the sale.  That gain will be taxed, or your loss will be subtracted from other gains, or up to $3,000 will be subtracted from your other income on your Federal tax return.  Any losses greater than $3,000 will be carried forward to future years.

If there is ever anything missing from the tax return information we receive to prepare tax returns, it is the cost basis of the investments sold during the year! 

Remember to keep the “BOT” statements from buying your investments.  They are your best proof of your investment cost down the road when you sell those investments!