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Have a look at Pub 564, Mutual Fund Distributions - there, you'll find more than you ever wanted to know about cost basis of liquidated funds. But to summarize:

- specific share identification means that you identify precisely which shares are to be sold, i.e., you say something like "sell the 100 shares acquired on 9/13/92 and 13.132 of the shares acquired on 11/2/94." You must then receive confirmation from the fund that they did just that.

- the alternative is FIFO, or "first in, first out", where it is assumed that the shares you sell are the earliest ones you bought.

FIFO is the IRS default, and is generally best for them, since over the long term, most funds (and equities) go *up* in price, and the oldest shares thus have the lowest price - and give you the largest capital gain. If you identify specific shares, presumably you would identify shares bought fairly late, i.e. at a higher price, and that would give you a smaller capital gain...

But wait, there's more! With mutual funds, you can also use what is called an "average basis" method. Here, you simply figure the average cost of all the shares you owned at the time you sold - that is, your total basis (the sum of all purchases, reinvested divs, and reinvested capital gains) divided by the number of shares you had. Then the basis of the shares you sell is just that average basis times the number of shares sold. Actually, there are *two* average basis methods - "single category" and "double category". In the latter, you divide your shares into short term and long term piles, figure the average basis for each, and specify to the broker which pile to sell from, again getting confirmation. One catch is that if you elect to use an average basis method, you have to keep using it forever, until your entire position is liquidated...

Personally, I think "average basis, single category" is easiest. And many funds will provide you with this average cost basis per share when you liquidate shares. As for which method is "best" - well, it depends! One thing to be aware of - if you liquidate *all* your shares, it doesn't matter what method you use! Your capital gain will be the same however you do it. And even if you calculate that average basis, for example, is cheaper (capital gains-wise) than FIFO, that's just a temporary condition. What you're really doing is putting off the final reckoning until later - you may pay less (cap gain) tax this year, but you'll pay more in future years. (This is the reason you have to stick with an average basis method once you choose it.) Anyway - by the time you sell your last share, you will wind up paying the same tax.

This is all spelled out in Pub 564, with some examples. It's instructive to work out, using sample data, the tax consequences of liquidating your shares over time, using specific share, FIFO, or average basis. You'll see, in particular, that over the long haul, your capital gain will be the same - the only difference is how the tax bill is spread out.

(I will remark that all of the above methods assume that you have good, accurate records of your investments over the years! A spreadsheet is ideal for something like this.)
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