Financial Terms / C - D / Cost basis

What is cost basis?

Cost basis is the original value of an asset for tax purposes. It's usually the purchase price, plus any additional costs like commissions or fees you paid to buy the asset. This figure is crucial for calculating your capital gains or losses when you sell an investment.

When you buy stocks or bonds, your cost basis is the purchase price plus any extra costs such as commissions and transfer fees. For example, if you buy shares for $1000 and pay a $10 commission, your cost basis is $1010.

Your cost basis can change over time. Things that can increase it include:

1. Reinvested dividends
2. Reinvested capital gains
3. Stock splits
4. Return of capital distributions

Understanding cost basis is key to managing your taxes. When you sell an investment, you'll need to know its cost basis to figure out your gain or loss. The IRS expects you to keep records of your cost basis for all your securities.

Here's why it matters: Let's say you bought a stock for $1000 and sold it for $1500 two years later. If you received $400 in reinvested dividends, your adjusted cost basis would be $1400. Your taxable gain would be $100 ($1500 - $1400), not $500 ($1500 - $1000).

If you can't determine your cost basis, you might have to treat it as zero. This could mean owing more in taxes. So, it's smart to keep good records of all your investment transactions.

How to Calculate Cost Basis

To calculate cost basis, you need to start with the original purchase price of an asset and factor in any additional costs or adjustments. Here's how to do it:

1. Begin with the purchase price: This is the amount you paid for the asset.
2. Add transaction costs: Include any fees or commissions paid when buying the asset.
3. Account for reinvested dividends: If you've reinvested dividends, add these to your cost basis.
4. Adjust for stock splits: If a stock split occurred, divide your original cost basis by the split ratio.
5. Consider improvements: For real estate, add the cost of major improvements to your basis.
6. Subtract certain factors: Deduct items like depreciation, insurance payments for losses, or energy improvement tax credits.

Different methods exist for calculating cost basis, each impacting your capital gains or losses differently:

1. First In, First Out (FIFO): Oldest shares are sold first.
2. Last In, First Out (LIFO): Most recent shares are sold first.
3. Average Cost: Calculates the average cost of all shares owned.
4. Specific Shares: You choose which shares to sell.

For stocks and mutual funds, your cost basis is typically the purchase price plus trading costs. With real estate, it includes the purchase price, closing costs, and the cost of improvements.

Remember, keeping accurate records of your investments is crucial for tax purposes. If you can't determine your cost basis, you might have to treat it as zero, potentially leading to higher taxes.

Methods for Determining Cost Basis

You have several methods to determine the cost basis of your investments. Each method can impact your capital gains or losses differently, so it's important to understand how they work.

First In, First Out (FIFO)

FIFO is the default method for most investments except mutual funds. With this approach, the shares you bought first are the first ones sold. It's straightforward and doesn't require you to hand-select which shares to sell. Sales and transfers are based on the acquisition date, not potential gains or losses.

Specific Identification

This method allows you to choose which shares to sell, giving you more control over your tax situation. It's often used for expensive items like furniture or vehicles. With specific identification, you can minimize gains, maximize losses, or realize long-term rather than short-term gains. However, it requires meticulous record-keeping.

Average Cost

Average cost is a simple method, often used as the default for mutual funds. It considers the total cost of your investment, including purchases, reinvested dividends, and capital gains. To calculate:

1. Add up the total purchase amount
2. Divide by the number of shares purchased

This gives you the average cost per share, which helps determine if you've gained or lost value when selling.

Each method has its advantages. FIFO is simple, specific identification offers flexibility, and average cost is straightforward for mutual funds. Choose the method that best fits your investment strategy and record-keeping abilities.

FAQs

1. How do I calculate my cost basis for shares?

To calculate your cost basis for shares, include the purchase price of the shares and any commissions paid. For example, if you bought 10 shares at USD 100.00 each and paid a 1% commission, your cost basis would be USD 1010.00 (USD 1000.00 + USD 10.00).

2. Why might my cost basis be more than the initial purchase price?

Your cost basis can exceed your initial purchase price due to additional costs such as commissions, fees, reinvested dividends, or capital gains distributions. These additional costs are included in the cost basis to reflect the total investment amount.

3. What are the implications of not having a cost basis?

If you do not have a documented cost basis, the IRS may assume it to be zero, resulting in the maximum tax liability. It is crucial to maintain records, as you must prove your cost basis if audited; otherwise, the IRS will set it to zero.

4. How does the IRS confirm the accuracy of a reported cost basis?

The IRS verifies a reported cost basis using original purchase documents and other records such as third-party data, bank statements, and market data. Taxpayers are expected to retain all relevant documentation of their capital assets to substantiate their claims.