Investors buy stocks for one major reason - to make money. In order to know whether an investment has provided those longed-for gains, investors need to keep track of portfolio performance. Understanding total cost basis, as well as complying with the implementation of recent changes to tax law, is critical to knowing if an investment is fruitful, which puts the onus of accurate cost basis reporting on investors.
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. The initial purchase price is only one part of the overall cost of an investment.
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 an investment to make informed buy or sell decisions.
Straightforward calculations of equity cost basis for a non-dividend paying stock are simple: purchase price per share plus fees per share. However, more often than not, other inputs need to be considered as well, such as reinvested dividends, stock splits, mergers or even bankrupt shares.
Reinvesting dividends increase the cost basis of a stock because dividends are used to buy more shares. For example if an investor bought 10 shares of ABC company for $1000 plus $10 trading fee and received dividends of $200 in year one and $400 in year two, cost basis would be $1610. If he or she then sold the stock in year three for $2000, the taxable gain would be $390.
One of the reasons investors need to include reinvested dividends is because dividends are taxed in the year received and if they are not included in cost basis, the investor will pay taxes on them twice. For instance in the above example, if dividends were excluded, cost basis would be $1010 and the taxable gain would be $990.
Corporate actions tend to impact cost basis calculations. Mergers, bankruptcy and stock splits are common corporate actions. When a company merges with another, investors may receive shares in the new company on a like basis or in addition to the number of shares previously owned. If the number of shares are the same then the cost basis does not change, but if the number of shares change then the cost basis needs to be amended.
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 SEC, which outlines the merger agreement and helps investors determine the new cost basis.
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; but if a company declares Chapter 11, then 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.
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, then the cost basis is 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 the Chapter 11 emergence plans.
Luckily, 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 $1000 stays the same, so the 20 shares would have a price of $50 per share and not $100.
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 cost basis for inherited stock is much easier than on a gift. Cost basis from inheritance becomes the average price on the date of the benefactor's death. Conversely, gifted stock is 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.
One reason for tracking equity cost basis is for tax reporting, because maintaining accurate accounting of cost basis assists in deciding when to sell shares for tax purposes. In addition, investors can choose, prior to selling shares, which accounting method they would like to use to calculate gain or loss. Simply said, an investor can choose which shares he or she would like to sell if he or she purchased shares at different times.
For example, an investor purchased shares of ABC company on three different dates at different prices: 10 shares @ $100/share in February, 30 shares @ $120/share in August and 15 shares @ $150/share in November. If he or she sells a portion of his or her 55 shares, the cost basis he or she decides to use for tax purposes may depend on the tax implication of the sale. There are three methods typically used: FIFO (first in first out), LIFO (last in first out) or the average.
Let's say the investor sold 20 shares. With FIFO, the cost basis will be recorded as (10 shares x $100/share) + (10 shares x $120/share) = $2200. With LIFO, the cost basis for 20 shares will be translated as (15 shares x $150/share) + (5 shares x $120/share) = $2850. The average cost basis just takes into account the average price of the purchases, which in this case would be 20 shares x [($100 x 10 + $120 x 30 + $150 x 15)]/55 = $2490.
The method chosen should be the most beneficial to the investor's tax situation. If the investor does not choose a method, FIFO is the default.
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 is 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 as 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 via sites such as Yahoo finance or USA today. For investors that self-track stocks, financial software such as Intuit's Quicken or Microsoft Money, or simply 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 more simplified.
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/loss profile of a stock position, as well as ensuring that capital gains/losses are accurately reported. Although brokerage firms tend to track and report this information to the IRS, there are situations where brokerage firms do not have the information, such as in the case of a gifted stock, so understanding how equity cost basis works will help investors properly determine it. In addition to brokerage firms, there are many other online resources available to assist in maintaining accurate basis.