Final answer:
The IRS uses the average of all purchase prices, known as the average cost basis method, to determine the cost basis of an investment bought in parts. This average provides a single per-share value that reflects the cost of all shares. Investors can also choose to specify which shares are being sold using the specific identification method.
Step-by-step explanation:
The IRS determines the cost basis of an investment bought in parts at different times using the average of all purchase prices, which is commonly referred to as the average cost basis method. For example, if an investor purchases shares of a stock at different prices over time, the IRS calculates the cost basis for the sale of those shares by averaging the purchase price of all the shares owned prior to the sale. This average cost basis provides a single per-share value that reflects the cost of all shares, irrespective of the separate purchase prices.
In practice, when an investor sells only a portion of their investment, they have the option to specify which shares are being sold (known as the specific identification method) or use the average cost basis. When using the average cost basis, the IRS requires that it be used consistently for subsequent sales of that particular investment. It's important for investors to maintain accurate records of their transactions to correctly calculate their cost basis when the time comes to sell their investments.