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. When it comes to securities and related financial assets, determining the initial cost basis for only one initial purchase is very straightforward. However, as is usually the case in investing, 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. Throw in a number of other issues that can impact cost basis, and the matter of calculating it accurately for personal records and tax purposes can get more complicated.
What is Cost Basis?
Cost basis starts as the original value of an asset for tax purposes, which is initially the first purchase price. 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 where a security is 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. This is also known as the "tax basis” and will be covered in more detail below.
How is it Calculated?
Once again, 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 as simple as keeping a record on what the original purchase price was. Note that it is allowable to include the cost of a trade, such as a stock-trade commission. This 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, or 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/share in June and then makes an additional purchase of 50 XYZ shares in September for $15/share. If he sold 120 shares, his cost basis using the FIFO method would be (100 x $20/share) + (20 x $15/share) = $2,300.
The average cost method may also be applicable and simply 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/share) + (50 x $15/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 applies. Most examples cover stocks. 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 an 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 a security for longer than a year will mean any capital gain qualifies for long-term status, which is much lower than ordinary income rates and falls 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 an investor and lets him or her know if trading strategies end up being simply profitable or lucrative over time. A steady string of losses may indicate a need to reevaluate the investment strategy.
More Complicated Examples
Calculating cost basis gets much more complicated as a result of corporate actions. This category includes items such as adjusting for stock splits and accounting for special dividends, 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.
According to CCH Capital Changes, a leading authority in helping the IRS and investors track cost basis for corporate actions, there are more than 1 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 site of a company’s website. These sources usually provide plenty of detail on M&A activity or spinoffs.
When a company you own is acquired by another company, the acquiring company will issue either stock, cash or a combination of both to complete the purchase. Payouts for cash will result in having to realize a portion of 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. This is also the case 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.
When it comes to securities that were inherited from a family member or other individual that passed away, the cost basis changes to when the individual passed. The gain (or loss, which can happen in the case of a down market) also automatically qualifies as a long-term gain. In terms of securities gifted by another individual to you, the original tax basis stays with the security. The only exception is if the cost basis is in a loss status when the gifting occurs. If this is the case, the tax cost can be reduced.
How to Keep 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 at all 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.
Keeping good records can also help simplify matters. Large brokers and custodians must track cost basis and keep everything electronically for investors to access. Investors can also use Excel at home and keep hard copies of trade confirmations, which can go back many years to the original purchase date.
The concept of cost basis is basically straightforward, but it can become complicated in many ways. Tracking cost basis is required for tax purposes but also is needed to help track and determine investment success. The key to success when it comes to tracking cost basis is to keep good records and simplify the investment strategy where possible.
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