Last week, we talked about the new Super-Long-Term holding period for capital gains taxes and the new discount rate earned by holding on to investments (bought after January 1, 2001) for greater than five years. Continuing with the theme of taxes this week, we now look at some of the issues unique to Drip investing that may arise when the Tax Man comes a collectin'.

The basics of basis
Drip investing usually involves several small purchases over great lengths of time. Investors are often confused about how to calculate the cost basis of these purchases after a sale. It's tempting to try and figure the average cost basis of all shares sold. Tempting, but not allowed. Individual stocks require an actual cost basis for each purchase so an average cannot be used. Instead, each of the many, many purchases in a Drip (including the reinvestment of dividends) will carry its own cost basis. Keep those year-end statements!

Commission charges should be attributed only to the actual shares that the commission was based on, and the commissions should be added to your cost basis for those shares. Administrative fees or service charges, on the other hand, cannot be added to the cost basis and should instead be deducted as a miscellaneous itemized deduction on Schedule A, subject to the 2% limitation on Adjusted Gross Income (AGI).

So, you ask, if I can't use an average cost basis, will I need to list each purchase on my tax return? Won't that be very tedious? Excellent question. Your parents raised a smart Fool.

The answer is no. While you cannot use an average cost basis, you are permitted to add all the like holding period bases together and list them on one respective line. Of the shares sold, add all purchases made more than one year ago and those made less than one year ago and list each total on Schedule D of your return. Beginning January 1, 2001, you can begin to work toward the super-long-term holding period of greater than five years.

If you do not sell all of the shares you own, you can determine which shares were sold using either the First In, First Out (FIFO) method or the Specific Identification method. FIFO means that the first share you sell was the first share you purchased. This is usually easiest and for most people optimizes the holding period associated with the sale.

The Specific Identification method takes a bit more work and involves identifying exactly which shares are to be sold in advance of the sale. While the Tax Court has determined there is no one exclusive manner for identifying shares, adequate records must be presented to show the specific shares that were sold in order to avoid FIFO.

Incoming dividends
If you hold the shares of a company that regularly pays a portion of its profits in the form of a dividend, you're receiving taxable income from these companies, regardless if you reinvest the dividends or accept them in cash. The company or its transfer agent will usually send you a 1099-DIV statement listing the year's worth of dividends paid. Sometimes, however, when the amount is less than $10, you may not receive a 1099-DIV. The income is still required to be reported, though, on an interest and dividend tax form. If you dont receive the 1099-DIV, you can determine the amount of dividend income received from your year-end account statements.

The cost of discounts and perks
Over 100 direct investing plans currently offer discounts on either cash purchases or dividend reinvestment. This is a nice way for a company to encourage investors to chose their plan, but it's not a total freebie. The discount you receive is considered taxable income to you and must be reported in the same manner as dividend income. The upside is that your cost basis is upgraded to the fair market value (FMV) on those discounted shares.

Another source of overlooked income is commissions or fees paid on your behalf by the company. This is another perk that comes at a cost to you except in the form of income on which youll pay taxes. It's important to look for any company-paid costs on your year-end statements and report them as income, in the same manner as dividend income.

For more information on a variety of tax issues, see the Fool's All About Taxes area, or pick up a copy of The Motley Fool Investment Tax Guide 2001.

Vince Hanks often gets lost on his way to the post office, but usually manages to get his tax returns in on time. To see the stocks he owns, view his profile. The Motley Fool is investors writing for investors.