It is important to understand that with nearly any investment, you must establish your "cost basis." The cost basis is the value used to determine whether you have a gain or loss for tax purposes.

For example, let's say you purchase 100 shares of XYZ Corp. at $20 per share on January 1. Your "cost basis" for those shares is $20 per share ($2000) plus your commission to purchase those shares.

Why is this cost basis important? Because when you sell those 100 shares, that cost basis will be used to determine your gain or loss, which, in turn, determines the amount of taxes you pay Uncle Sam.

Getting back to our example, let's say you sell the 100 shares of XYZ 14 months later at a price of $30 per share. Since your cost basis is $20, you would have a profit of roughly $10 per share, or $1000. Since you held the investment for more than 12 months, you would be taxed on that capital gain at favorable long-term tax rates of no more than 20%. Thus, assuming a 20% long-term capital-gains rate, you would pay $200 in taxes on the investment gain when you filed your income tax form for that year.

Interestingly, had you held the investment for less than 12 months, you could pay as much as 39.6% in taxes on the gain, meaning you would pay nearly $400 in taxes if you were in the top tax bracket.

When determining a stock's cost basis, keep in mind that stock splits require you to adjust your cost basis.

For example, had XYZ Corp. split 2-for-1 prior to your sale, your new cost basis on the 100 shares you purchased would have been $10 per share (the $20 per share purchase price adjusted for the 2-for-1 stock split).

Another point to remember is that you have some control over how the cost basis is determined. Investors can choose one of two methods for determining the cost basis - the "first in, first out" method or the "specific share" method.

Using the first in, first out method, you would use the cost basis on the oldest shares purchased. For example, let's say you made four individual purchases of the same stock. With the first in, first out method, you would account for the cost basis using the cost basis of the earliest shares purchased first.

Conversely, if you use the specific share method, you could pinpoint which shares you want to sell. Thus, you could choose the newest shares you purchased. This is significant since you could pick the shares with the highest cost basis.

The specific share method is usually more tax friendly since you can choose the shares with the highest cost per share to sell first, thus lowering your gain and the amount of taxes you pay Uncle Sam.

One last point is worth mentioning. If you sell only part of a stock holding, you cannot use an "average cost" computation. You can only use an average cost computation when selling stocks if you sell all of your holding in that particular stock.