Q: When selling a stock that I bought at different prices at different times, do I have to determine the cost basis by the first-in, first-out method?

A: Few things hang up investors as much as taxes. And at the top of the list of questions that perplex investors most is how to determine an investment’s cost basis.

Simply stated, your cost basis in a stock or mutual fund is how much you paid for that investment, including any fees and commissions. The cost basis is a critical piece of information, because it determines how much you’ve made or lost. And that gain or loss is what determines how much tax you pay when you sell the investment.

If you buy a stock for $10 a share and sell it for $12, the cost basis rule is pretty simple. You only have one lot of stock, meaning you bought all the shares at the same time and at the same price. Your cost basis is $10 and you sell for $12, so your profit is $2 per share.

It gets more complicated when you buy a stock at different prices, or in different lots. Let’s say you first bought 100 shares of stock at $10, another 10 at $13 and then 2 shares at $11 each. What is the cost basis?

Generally speaking, the Internal Revenue Service defaults to the first-in, first-out method, or FIFO if you sell only part of those shares. That means when you sell, unless you say otherwise, the IRS assumes you’ll take the cost basis of the shares you bought first. Going back to the example above, if you sell 10 shares, the IRS would assume your cost basis is $10.

The problem with FIFO is that it usually, but not always, results in the greatest amount of tax due, because stock prices tend to go up. That’s why you might consider one of the three other methods permitted by the IRS, according to the Ernst & Young Tax Guide 2008. Those are:

The specific identification method. You tell the IRS which lot of stock you sold from. In the example above, you could say the 10 shares you sold were from the second lot, which had a cost basis of $13 a share. To do this, though, you need to tell your broker to sell shares from that lot at the time of sale. You must also have written confirmation that you told the broker to sell the shares from the specific lot and be prepared to prove it.

Single-category method using the average approach. When you sell stock, you take the average cost basis of all the shares from all the lots you owned at the time of the sale. You calculate this by adding up the cost of all the stocks, including commissions and fees, divided by the total number of shares.

If you’re going to use this method, you need to attach a statement with your tax return. And if you start using it with a mutual fund, you must keep using it for the same fund.

Double-category method using the average approach. This is similar to the single-category approach, except that here, you determine the cost basis of the shares depending on how long you have owned them. If you held some shares less than a year, it’s a short-term holding and will be taxed at the short-term capital gains rate. If you’ve held shares a year or more, that’s a long-term holding, and any profits will be considered long-term capital gains, with a more favorable tax rate.

You calculate the average cost for each category. Again, if you’re going to use this method you need to inform the IRS at the time of your tax filing.

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.