Last week, we discussed 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. With just a few weeks before taxes come due, today we look at some issues unique to Drip investing that may arise when the Tax Man comes a-collectin'.

Selling and the basics of cost 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 to 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 purchases in a Drip (including the reinvestment of dividends) will carry its own cost basis. Keep those year-end statements!

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. And with purchases made after 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 typically determine which shares were sold using either the First In First Out (FIFO) 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.

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).

Incoming dividends
If you hold shares of a company that regularly pays a portion of its profits in the form of a dividend, you're receiving taxable income from the company, regardless of whether 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 don't 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
More than 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 choose their plan, but it's not a total freebie. The discount that you receive is considered taxable income and must be reported in the same manner as dividend income. The upside is that your cost basis on these discounted shares is upgraded to the current fair market value (FMV).

Other sources of often overlooked income are commissions or fees paid on your behalf by the company. This is another perk of Dripping that comes at no cost to you except in the form of income on which you'll pay taxes. It's important to look for any company-paid costs (shown in their own little box) on your year-end Drip statements or in some cases on your 1099-DIV and report them as income, in the same manner as dividend income. Thankfully, these costs paid for you are usually very low and won't affect your taxes, but you still need to report them.

For more information on a variety of tax issues, see the Fool's friendly All About Taxes area, or pick up a copy of The Motley Fool Tax Guide 2002. If your taxes are more complex (estate or small business tax issues, inheritance income, lots of writeoffs, etc.), consider TMF Money Advisor, which for just $149 a year gives you access to a financial advisor who can answer your questions and has nothing to sell you. TMF Money Advisor also gives you free access to the entire online Fool community and a free copy of the Fool's 2002 Tax Guide.

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