Figuring your basis for ETFs

Exchange-traded funds (ETFs) are an investment vehicle which has some features of both individual stocks and mutual funds. In order to determine your gain or loss when you sell shares in ETFs, you need to know your basis. This is a tax term that has special meaning.

General rule

Like stock, an investor’s basis in ETF shares usually is based on cost—what you paid for the shares, plus any sales commissions. However, if you did not buy the shares yourself, there are other ways to determine basis:

• If you acquire shares by inheritance, your basis is the shares’ value for estate tax purposes (usually fixed on the date of the decedent’s death).
• If you received shares as a gift, your basis usually is the same as the basis of the person who made the gift; ask that person for basis information.

Adjustments to basis

Basis in a fund set up as an open-end fund or unit investment trust (UIT) is increased by any taxable dividends that are reinvested in additional ETF shares. Basis in EFT set up as a master limited partnership (MLP) has different basis adjustments.

Tracking basis

It is important for you to keep track of basis so you can make smart decisions about selling for tax advantage. For example, if you acquire shares in the same ETF at different prices, your basis in all the shares is the sum of everything you paid. However, if you decide to sell less than your entire holdings in the ETF, you’ll need a basis breakdown if you want to sell and minimize your tax results.

If you do nothing—simply ask to sell a certain number of shares in the ETF—you are presumed to have sold the first shares acquired. This is referred to a FIFO, or first in, first out. However, if you identify which shares you want to sell, you can choose those that produce the lowest gain or the greatest loss, depending on the situation.

For example, say you bought 100 shares of the S&P 500 SPDR at $67 in March 2009. You also bought 100 shares in January 2011 at $110. In July 2013, you sell 50 shares at $155. If you do nothing, you are presumed to have sold 50 of the shares for which you paid $67, which would give you an $88 profit per share (ignoring transaction costs for the purpose of the example). However, if you identify the shares that you wish to sell and name those purchased in 2011, your gain is only $45 per share.

You may also be able to use the average cost basis method for your ETF holdings; check with the firm that sold you the ETF to see if your shares are eligible for averaging.

Reporting basis

While it is vital for you to track your own basis, financial institutions are now required to do so, as well for stock shares purchased after 2010. Basis must be reported to the IRS and to the investor on Form 1099-B when shares acquired after 2010 are sold. Basis may be reported even for ETF shares acquired before 2011.

Some ETF shares are treated by the IRS as stock for basis-reporting purposes. Reporting may currently apply to certain ETFs while not to others, depending on how the ETFs are organized from a legal standpoint. Some investment firms are including the basis of ETFs bought and sold in 2011 on the 1099s provided to investors in 2012. Other firms waited until 2013 to start such reporting, since for most ETFs the reporting requirement takes effect for shares acquired after 2011 (reporting basis for mutual fund shares also begins for shares acquired after 2011).

Looking ahead, firms will continue to track the basis for ETF purchases so that more basis information will be made available to the IRS and investors in years to come.

Final Word

It may be helpful to retain confirmation statements whenever you purchase ETF shares. Work with your tax advisor to make sure your actions with respect to ETF holdings optimize tax results.