How to Correctly Understand It

What Is Cost Basis?

Cost basis is the original value or purchase price of an asset or investment for tax purposes. The cost basis value is used in the calculation of capital gains or losses, which is the difference between the selling price and purchase price.

Calculating the total cost basis is critical to understanding if an investment is profitable or not, and any possible tax consequences. If investors want to know whether an investment has provided those longed-for gains, they need to keep track of the investment’s performance. 

Understanding Cost Basis

Cost basis starts as the original cost of an asset for tax purposes, which is initially the first purchase price. But the initial purchase price is only one part of the overall cost of an investment. As time moves forward, this cost basis will be adjusted for financial and corporate developments such as stock splits, dividends, and return of capital distributions. The latter is common with certain investments such as Master Limited Partnerships (MLPs).

Cost basis is used to determine the capital gains tax rate, which is equal to the difference between the asset’s cost basis and the current market value. Of course, this rate is triggered when an asset is sold, or the gain or loss is realized. Tax basis still holds for unrealized gains or losses when securities are held but has not been officially sold, but taxing authorities will require a determination of the capital gains rate, which can be either short term or long term.

Tax Reporting Cost Basis

Although brokerage firms are required to report the price paid for taxable securities to the IRS, for some securities, such as those held for a long period of time or those transferred from another brokerage firm, the historical cost basis will need to be provided by the investor. All of which puts the onus of accurate cost basis reporting on investors.

Determining the initial cost basis of securities and financial assets for only one initial purchase is very straightforward. In reality, there can be subsequent purchases and sales as an investor makes decisions to implement specific trading strategies and maximize profit potential to impact an overall portfolio. With all of the various types of investments, including stocks, bonds, and options, calculating cost basis accurately for tax purposes, can get complicated.

In any transaction between a buyer and seller, the initial price paid in exchange for a product or service will qualify as the cost basis. The equity cost basis is the total cost to an investor; this amount includes the purchase price per share plus reinvested dividends and commissions. Equity cost basis is not only required to determine how much, if any, taxes need to be paid on an investment, but is critical in tracking the gains or losses on investment to make informed buy or sell decisions.

Calculating Cost Basis

As stated earlier, the cost basis of any investment is equal to the original purchase price of an asset. Every investment will start out with this status, and if it ends up being the only purchase, determining the cost is merely the original purchase price. Note that it is allowable to include the cost of a trade, such as a stock-trade commission, which can also be used to reduce the eventual sales price.

Once subsequent purchases are made, the need arises to track each purchase date and value. For tax purposes, the method used by the Internal Revenue Service (IRS) is first-in, first-out (FIFO) for those familiar with the inventory tracking method for businesses. In other words, when a sale is made, the cost basis on the original purchase would first be used and would follow a progression through the purchase history.

For example, let’s assume Lawrence purchased 100 shares of XYZ for $20 per share in June and then makes an additional purchase of 50 XYZ shares in September for $15 per share.

If he sold 120 shares, his cost basis using the FIFO method would be (100 x $20 per share) + (20 x $15 per share) = $2,300. The average cost method may also be applicable and represents the total dollar amount of shares purchased, divided by the total number of shares purchased. If Lawrence sold 120 shares, his average cost basis would be 120 x [(100 x $20 per share) + (50 x $15 per share)]/ 150 = $2,200.

IRS publications, such as Publication 550, can help an investor learn which method is applicable for certain securities. Otherwise, an accountant can help determine the best course of action. There are also differences among securities, but the basic concept of what the purchase price is applied. Typically, most examples cover stocks. However, bonds are somewhat unique in that the purchase price above or below par must be amortized until maturity. For mutual funds, gains must be paid out annually to shareholders, which triggers a taxable event in taxable (nonqualified) accounts. All amounts will be tracked by a custodian or guidance will be provided by the mutual fund firm.

Why Is Cost Basis Important?

The need to track the cost basis for investment is needed mainly for tax purposes. Without this requirement, there is a solid case to be made that most investors would not bother keeping such detailed records. And because taxes on capital gains can be as high as ordinary income rates (in the case of the short-term capital gains tax rate), 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, it is important to know how an investment has performed over time. Savvy investors know what they have paid for a security and how much in taxes they will 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.

Dividends 

The equity cost basis for a non-dividend paying stock is calculated by adding the purchase price per share plus fees per share. Reinvesting dividends increases the cost basis of the holding because dividends are used to buy more shares. 

For example, let’s say an investor bought 10 shares of ABC company for a total investment of $1,000 plus $10 trading fee. The investor was paid dividends of $200 in year one and $400 in year two. The cost basis would be $1,610 ($1,000 + $10 fee + $600 in dividends). If the investor sold the stock in year three for $2,000, the taxable gain would be $390. 

One of the reasons investors need to include reinvested dividends into the cost basis total is because dividends are taxed in the year received. If the dividends received are not included in cost basis, the investor will pay taxes on them twice. For instance, in the above example, if dividends were excluded, the cost basis would be $1,010 ($1,000 + $10 Fee). As a result, the taxable gain would be $990 ($2,000 – $1,010 cost basis) versus $390 had the dividend income been included in the cost basis. 

In other words, when selling an investment, investors pay taxes on the capital gains based on the selling price and the cost basis. However, dividends get taxed as income in the year they’re paid to the investor, regardless of whether the dividends were reinvested or paid out as cash.

Examples of Cost Basis

Calculating the cost basis gets more complicated as a result of corporate actions. Corporate actions include items such as adjusting for stock splits and accounting for special dividends, bankruptcies, and capital distributions, as well as merger and acquisition activity and corporate spinoffs. A stock split, such as a two-for-one split where a company issues an additional share for every share an investor owns, doesn’t change the overall cost basis. But it does mean the cost per share becomes divided by two, or whatever the share exchange ratio ends up being following the split.

According to CCH Capital Changes, a leading authority in helping the IRS and investors track cost basis for corporate actions, there are more than one million corporate action activities each year. Determining the impact of corporate actions isn’t overly complicated, but it can require sleuthing skills such as locating a CCH manual from a local library or heading to the investor relations section of a company’s website. These sources usually provide plenty of detail on M&A activity or spinoffs.

Mergers

When a company you own is acquired by another company, the acquiring company will issue stock, cash, or a combination of both to complete the purchase. Payouts for cash will result in having to realize a portion as a gain and pay taxes on it. The issuance of shares will likely keep capital gains or losses as unrealized, but it will be necessary to track the new cost. Companies provide guidance on the percentages and breakdowns. The same rules also apply for when a company spins out a division into its own new company. Some of the tax cost will go with the new firm, and it will be necessary for the investor to determine the percentage, which the company will provide.

For example, if XYZ company buys ABC company and issues two shares for every one share previously owned, then the investor referred to in the previous example now owns 20 shares of XYZ company. Companies need to file Form S-4 with the Securities and Exchange Commission (SEC), which outlines the merger agreement and helps investors determine the new cost basis.

Bankruptcies

Bankruptcy situations are even more complicated. When companies declare bankruptcy, the impact on shares varies. Declaring bankruptcy does not always indicate that shares are worthless. If a company declares Chapter 7, then the company ceases to exist, and the shares are worthless.

However, if a company declares Chapter 11, the stock may still trade on an exchange or over the counter (OTC) and still retain some value. Therefore the initial cost basis calculations apply. OTC is a broker-dealer network that trades securities that are not listed on a formal exchange.

However, if the bondholder of a company emerging from Chapter 11 is given common stock in exchange for some of the bonds held prior to declaring bankruptcy, the cost basis becomes more complicated. The cost basis would typically be considered the fair market value of the common stock on the effective date; this value is laid out in Chapter 11 emergence plans.

Stock Splits

Thankfully, not all corporate actions complicate cost basis calculations; declaring a stock split is one such action. For example, if a company declares a 2 for 1 split, instead of owning 10 shares of ABC company, an investor would own 20 shares. However, the initial cost of $1,000 stays the same, so the 20 shares would have a price of $50 instead of $100 per share.

Inherited Stocks and Gifts

In addition to corporate actions, other situations can impact the cost basis; one such situation is receiving a stock gift or inheritance. Calculating the cost basis for inherited stock is done by taking the average price on the date of the benefactor’s death.

Conversely, a gifted stock is more complicated. If an investor sells the stock, cost basis becomes the purchase price on the date the gifter bought the stock, unless the price is lower on the date of the gift. If this is the case, the tax cost can be reduced, since the stock has suffered a loss in value.

Keeping It Simple

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, it’s always wise for investors to maintain their own records by self-tracking to ensure accuracy of the brokerage firm’s 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 to calculate cost basis. Historical prices can be readily found on the internet. For investors that self-track stocks, financial software such as Intuit’s Quicken, Microsoft Money, or using a spreadsheet like Microsoft Excel, can be used to 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 tracking and maintaining accurate records easier. 

The Bottom Line

Equity cost basis is important for investors to calculate and track when managing a portfolio and for tax reporting. Calculating equity cost basis is typically more complicated than summing the purchase price with fees. Continual monitoring of corporate actions is important to ensure that investors understand the gain or loss profile of a stock position, as well as ensuring that capital gains and losses are accurately reported. Although brokerage firms tend to track and report this information to the IRS, there are situations where they do not have it, such as in the case of a gifted stock. In addition to brokerage firms, there are many other online resources available to assist in maintaining accurate basis.

The concept of cost basis is fairly straightforward, but it can become complicated. Tracking cost basis is required for tax purposes but also is needed to help track and determine investment success. It’s important to keep good records and simplify the investment strategy where possible.