A:

The cost basis of any investment is the original value of an asset adjusted for stock splits, dividends and capital distributions. It is used to calculate the capital gain or loss on an investment for tax purposes.

At the most basic level, the cost basis of an investment is just the total amount invested into the company plus any commissions involved in the purchase. This can either be described in terms of the dollar amount of the investment, or the effective per share price that you paid for the investment.

The calculation of cost basis can be complicated, however, due to the many changes that will occur in the financial markets such as splits and takeovers. For the sake of simplicity, we will not include commissions in the following examples, but this can be done simply by adding the commission amount to the investment amount ($10,000 + $100 in commissions = $10,100 cost basis).

Imagine that you invested $10,000 in ABC Inc., which gave you 1,000 shares in the company. The cost basis of the investment is $10,000, but it is more often expressed in terms of a per share basis, so for this investment it would be $10 ($10,000/1,000). After a year has passed, the value of the investment has risen to $15 per share, and you decide to sell. In this case, you will need to know your cost basis to calculate the tax amount for which you are liable. Your investment has risen to $15,000 from $10,000, so you face capital gains tax on the $5,000 ($15 - $10 x 1,000 shares). (For further reading, see A Long-Term Mindset Meets Dreaded Capital Gains Tax and Tax Tips For The Individual Investor.)

If the company splits its shares, this will affect your cost basis per share. Remember, however, that while a split changes an investor's number of shares outstanding, it is a cosmetic change that affects neither the actual value of the original investment, nor the current investment. Continuing with the above example, imagine that the company issued a 2:1 stock split where one old share gets you two new shares. You can calculate you cost basis per share in two ways: First, you can take the original investment amount ($10,000) and divide it by the new amount of shares you hold (2,000 shares) to arrive at the new per share cost basis ($5 $10,000/2,000). The other way is to take your previous cost basis per share ($10) and divide it by the split factor (2:1). So in this case, you would divide $10 by 2 to get to $5. (For more insight, check out Understanding Stock Splits.)

However, if the company's share price has fallen to $5 and you want to invest another $10,000 (2,000 shares) at this discounted price, this will change the total cost basis of your investment in that company. There are several issues that come up when numerous investments have been made. The Internal Revenue Service (IRS) says that if you can identify the shares that have been sold, then their cost basis can be used. For example, if you sell the original 1,000 shares, your cost basis is $10. This is not always easy to do, so if you can't make this identification, the IRS says you need to use a first in, first out (FIFO) method. Therefore, if you were to sell 1,500 shares, the first 1,000 shares would be based on the original or oldest cost basis of $10, followed by 500 shares at a cost basis of $5. This would leave you with 1,500 shares at a cost basis of $5 to be sold at another time.

In the event that the shares were given to you as a gift, your cost basis is the cost basis of the original holder, or the person who gave you the gift. If the shares are trading at a lower price than when the shares were gifted, the lower rate is the cost basis. If the shares were given to you as inheritance, the cost basis of the shares for the inheritor is the current market price of the shares on the date of the original owner's death. There are so many different situations that will affect your cost basis and because of its importance with regards to taxes, if you are in a situation in which your true cost basis is unclear, please consult a financial advisor, accountant or tax lawyer.

For more on how to use cost basis, check out Using Tax Lots: A Way To Minimize Taxes.

RELATED FAQS
  1. How do you calculate the cost basis for a mutual fund over an extended time period?

    Investors must pay taxes on any investment gains they realize. Subsequently, any capital gain realized by an investor over ... Read Answer >>
  2. What is an adjusted cost basis and how is it calculated?

    Learn what adjusted cost basis is, how it is calculated, and why this metric is important for investors, business owners ... Read Answer >>
  3. How do I calculate my gains and/or losses when I sell a stock?

    To begin, you need to know your cost basis, or the price you paid for the stock. If you did not record this information, ... Read Answer >>
  4. If I owned stock that split last year, how does this affect my taxes?

    Find out why standard stock splits do not change the value of an investor's portfolio and are unlikely to directly affect ... Read Answer >>
  5. Are stock dividends and stock splits taxed?

    Understand different tax implications for dividend payments and stock splits; main factors include the type of account and ... Read Answer >>
  6. What cost basis reporting rules are set by the Internal Revenue Service (IRS)?

    Read about the cost basis reporting regulations imposed by the Internal Revenue Service and some options available to individual ... Read Answer >>
Related Articles
  1. Investing Basics

    Know Your Stock Cost Basis

    Understanding equity cost basis is critical for tracking the gains or losses of an investment.
  2. Investing Basics

    What Determines Your Cost Basis?

    In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ...
  3. Professionals

    Holding Period and Cost Basis

    NASAA Series 65: Section 13 Holding Period and Cost Basis. In this section cost basis, stepped-up cost basis and receiving investment as a gift.
  4. Professionals

    Selling Mutual Fund Shares

    FINRA/NASAA Series 66 Section 2 - Selling Mutual Fund Shares. This section discusses the tax impact of selling mutual fund shares such as tax rate, holding period, cost basis, netting capital ...
  5. Professionals

    Tax Issues

    FINRA/NASAA Series 66: Section 3 Tax Issues. This section discusses income tax, holding period and cost basis in detail.
  6. Investing Basics

    Know Your Stock Cost Basis

    A stock’s cost basis is its purchase price plus all reinvested dividends and commissions.
  7. Professionals

    Basis

    Basis
  8. Investing Basics

    Cost Basis Basics

    The term "cost basis" refers to the original value of a security you own. When you sell a stock, bond or mutual fund, you use the cost basis to determine your profit or loss, which in turn affects ...
  9. Professionals

    Calculating Gains and Losses

    FINRA Series 6 Exam Study Guide - Calculating Gains and Losses. In this section: cost basis, netting capital gains and losses, exchanges and wash sales.
  10. Investing Basics

    Stock Splits: A Closer Look At Its Effects

    Most trades, including short sales and options, aren't materially affected by a stock split. Still, it's important for shareholders to understand how these events impact various aspects of investing. ...
RELATED TERMS
  1. Cost Basis

    1. The original value of an asset for tax purposes (usually the ...
  2. Average Cost Basis Method

    A system of calculating the cost basis on mutual fund positions ...
  3. Yield On Cost - YOC

    The annual dividend rate of a security divided by the average ...
  4. IRS Publication 551 - Basis Of Assets

    A document published by the Internal Revenue Service (IRS) that ...
  5. Stock Split

    A corporate action in which a company divides its existing shares ...
  6. Per Share Basis

    A measure used in the financial world to illustrate the quantity ...

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center