Cost basis is an important concept for investors to understand. In simple terms cost basis refers to the original value or cost of an asset like a stock, bond, or property. It’s used to calculate capital gains or losses when you sell the asset. Knowing your cost basis helps determine your tax liability on investment gains.
I’ll explain cost basis in more detail below, covering key topics like:
- What cost basis is
- Why it matters for taxes
- How to calculate cost basis
- Adjusted cost basis
- Inherited assets and gifted assets
- Capital gains and losses
- Cost basis methods
What Is Cost Basis?
Cost basis refers to the original value or cost of an investment when you first acquire it
For example, if you buy a share of stock for $50, your cost basis is $50 per share. If you buy a rental property for $200,000, your cost basis is $200,000.
This original cost serves as a reference point for calculating capital gains or losses when you eventually sell the investment.
The IRS defines cost basis as the “original value of an asset for tax purposes.”
Why Cost Basis Matters for Taxes
When you sell an investment at a profit, you owe capital gains taxes. Your capital gain or loss is determined by comparing the sale price to the original cost basis.
-
If you sell for more than your cost basis, you have a capital gain.
-
If you sell for less than your cost basis, you have a capital loss.
-
If you sell for exactly your cost basis, you have no gain or loss.
The capital gain or loss determines your tax liability. Knowing your accurate cost basis is crucial for reporting investment gains and losses on your tax return.
How to Calculate Cost Basis
For stocks and bonds, your cost basis is generally what you paid to purchase the investment. This includes:
- The share price or principal amount
- Any commissions or fees to buy the asset
For example:
- You buy 100 shares of ABC stock at $50 per share = $5,000
- You pay a $10 commission to your brokerage firm
- Your total cost basis is $5,010
For real estate like rental properties, your cost basis includes:
- The purchase price
- Closing costs like title fees, attorney fees, inspection costs
- Improvements or additions made over the years
Be sure to keep records like receipts and settlement statements to document your cost basis.
Adjusted Cost Basis
Your original cost basis can change over time. Certain events can increase or decrease your cost basis, resulting in an adjusted cost basis.
Common reasons for adjustments include:
-
Reinvested dividends or capital gains distributions – This increases your cost basis since you’re using the distributions to buy more shares.
-
Stock splits – A stock split increases the number of shares you own, decreasing your per share cost basis. But your total cost basis for the position stays the same.
-
Return of capital distributions – This decreases your cost basis per share.
-
Wash sales – Selling an investment at a loss then repurchasing it within 30 days creates a wash sale. This increases your cost basis in the repurchased shares.
-
Gifts – If you’re gifted an investment, your cost basis is generally the giver’s cost basis if they also provide documentation.
-
Inheritance – Your cost basis in an inherited investment is its fair market value on the date of death.
Always be sure to account for events that might adjust your original cost basis over time.
Inherited Assets and Gifted Assets
Special rules apply when determining the cost basis for gifted and inherited investments.
For assets received as a gift, your cost basis is the same as the giver’s cost basis in the investment if records are available. This is known as “carryover basis.”
For inherited assets like stocks and real estate, your cost basis is the fair market value as of the original owner’s date of death. This is known as “stepped-up basis.”
Having documentation from the giver or estate helps establish cost basis for tax purposes.
Capital Gains and Losses
When you sell an investment, your capital gain or loss is the difference between the sale price and your adjusted cost basis.
Capital gain = Sale Price – Adjusted Cost Basis
-
If the sale price is higher, you have a capital gain.
-
If the sale price is lower, you have a capital loss.
Capital gains are typically taxed at lower rates than ordinary income. The rate depends on your income and how long you held the asset. Short-term capital gains are taxed as ordinary income.
Capital losses can be used to offset capital gains. You can also deduct up to $3,000 in net capital losses per year to offset other income.
Cost Basis Methods
When selling part of a position, you need to determine which shares are sold to calculate your capital gain or loss accurately. IRS rules require using certain cost basis accounting methods.
Common methods include:
-
First In, First Out (FIFO) – Shares purchased first are sold first.
-
Last In, First Out (LIFO) – Newest shares purchased are sold first.
-
Average Cost – Cost basis averaged across all shares in the position.
-
Specific Identification – You specify exactly which share lots to sell.
Choosing the optimal method can help minimize your capital gains. Your brokerage will use the default method on your account, but you can request to change it.
In Summary:
-
Cost basis is the original value of an investment when first acquired.
-
It’s used to determine capital gains or losses upon selling for a profit or loss.
-
Make sure to account for adjustments to your initial cost over time.
-
Inherited and gifted assets have special cost basis rules.
-
Choosing the right accounting method can optimize your tax liability.
Tracking Cost Basis
Several methods can help minimize the paperwork and time needed to track cost basis. Companies offer dividend reinvestment plans (DRIPs) that allow dividends to be used to buy additional stock in the firm. If possible, keep these programs in a qualified account where capital gains and losses don’t need to be tracked. Every new DRIP purchase results in a new tax lot. The same goes for automatic reinvestment programs, such as investing $1,000 every month from a checking account. New purchases always mean new tax lots.
The easiest way to track and calculate cost basis is through brokerage firms. Whether an investor has an online or traditional brokerage account, firms have very sophisticated systems that maintain records of transactions and corporate actions related to stocks.
However, its always wise for investors to maintain their records by self-tracking to ensure the accuracy of the brokerage firms reports. Self-tracking will also alleviate any future problems if investors switch firms, gift stock, or leave stocks to a beneficiary as an inheritance.
For stocks that have been held over many years outside of a brokerage firm, investors may need to look up historical prices, found on the internet, to calculate the cost basis.
For investors who self-track stocks, financial software such as Intuits Quicken, Microsoft Money, or Microsoft Excel, can organize the data. Lastly, websites such as GainsKeeper or Netbasis, are available to provide cost basis and other reporting services for investors. All of these resources make it easier to track and maintain accurate records.
Why Is Cost Basis Important?
Cost basis primarily needs to be tracked for tax purposes. Without this requirement, it is likely that most investors would not bother keeping such detailed records.
Capital gains can be taxed at ordinary income rates in the case of short-term capital gains, so it pays to minimize them if at all possible. Holding securities for longer than one year qualifies the investment as a long-term investment, which carries a much lower tax rate than ordinary income rates and decreases based on income levels.
In addition to the IRS requirement to report capital gains, its wise to track how an investment has performed over time. Savvy investors know what they have paid for a security and how much in taxes they have to pay if they sell it.
Tracking gains and losses over time also serves as a scorecard for investors and lets them know if their trading strategies are generating profits or losses. A steady string of losses may indicate a need to reevaluate the investment strategy.
Investopedia Video: Cost Basis Basics
What is the difference between cost basis and tax basis?
Cost basis is the original cost of obtaining an asset. It can include the purchase price and any fees. During the time that an asset is held, its value can change due to changes in market value, as well as any depreciation. The tax basis is the adjusted cost basis of the asset at the time the asset is sold.
What is cost basis?
Cost basis refers to the original price of an asset. Cost basis is sometimes called tax basis. How Does Cost Basis Work? Let’s assume you purchase 100 shares of XYZ Company stock for $5 per share, and you pay a $10 commission for the purchase. Your cost basis would be:
What is the difference between cost basis and capital gains?
The term can also be used to describe the difference between the cash price and the futures price of a given commodity. Cost basis is the original price that an asset was acquired for, for tax purposes. Capital gains are computed by calculating the difference from the sale price to the cost basis.
What is a stock’s cost basis?
If your true cost basis is unclear, please consult a financial advisor, accountant or tax lawyer. Two ways exist to calculate a stock’s cost basis, which is basically is its original value adjusted for splits, dividends, and capital distributions.
