The Average Cost Double Category method is only available to use for mutual fund holdings and dividend reinvestment plans until 4/1/2011. It involves calculating the average cost separately for two buckets of tax lots--one short-term (less than one year since purchase) and the other long-term holdings.
This method cannot be used if you have any shares in physical certificate form.
To apply this method, follow the same steps as in the Average Cost Single Category, but use two separate pools of tax lots. It is a little more complicated because as time passes, each new tax lot will transfer from the short-term pool to the long-term pool.
This method is particularly advantageous if you have a loss on your sale because it preserves the character of the loss on the short-term tax lots (held less than one year) as a short-term capital loss which can be deducted from your other short-term capital gains which would otherwise be taxed at ordinary income tax rates. It therefore maximizes the tax savings from your loss.
Previously you had to elect the Double Category Method on your tax return and request permission from the IRS on Form 3115 to change methods after your initial election. However, since the publication of Treasury Regulations in October 2010, things have changed dramatically. You no longer need to request permission to change cost basis matching elections; the IRS decided that the choice of method of matching cost for individual trades does not rise to the level of a change in tax accounting method. Use of the double category method is only allowed up until 4/1/2011. It is no great loss as it was way too complicated for most people to apply anyway.
Click on the Excel worksheet icon to the right for a detailed eight page example of the application of the double category cost basis accounting method.
In applying the double category method, at the time of each disposition, all shares in an account are divided into two categories: short-term and long-term. The average basis for all the shares in the category becomes the basis for each share in the category. The average basis is the total dollar basis of all shares in that category at the time of disposition divided by the total number of shares in that category.
To use this method, you must specify to the custodian or broker/dealer which category is to be sold and receive written confirmation of the specification. If you do not specify and receive written confirmation, the earliest long-term tax lot must be used in determining which tax lots were liquidated.
After you have held a share for more than one year, you transfer it to the long-term category. The cost basis of the short-term share at the time of category transfer is the actual acquisition cost unless some of the short-term category shares have been sold. In that case, the basis of the transferred share is the average basis of all the shares in the short-term category at the time of disposition. At the instant that the shares enter the long-term category, their basis is then redetermined by adding the short-term status basis (determined according to the preceding rule) to the existing total long-term category cost basis. You then recalculate the average cost basis for all long-term shares.
You can see why every mutual fund company uses the single category average cost method on their statements. It is much easier to apply.
Further information can be found in IRS Publication 564, Mutual Fund Distributions. Just click on the "PDF" icon to the right to download a copy.
Information provided is intended solely for cash-basis U.S. citizen individual taxpayers and is believed to be accurate for most cases but is not guaranteed. Always consult your personal tax advisor about your own situation. Suggestions are most welcome. Please email our webmaster @ costbasis.com with your comments. If this website has been helpful to you, please consider making a donation to support our efforts.