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.
What Is the Cost Basis?
At the most basic level, the cost basis of an investment is 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 paid for the investment.
However, the actual calculation of cost basis can be complicated due to the many changes occurring in the market, such as splits and takeovers. For the sake of simplicity, we will not include commissions in the following examples, but this can be done by adding the commission amount to the investment amount ($10,000 + $100 in commissions = $10,100 cost basis).
Cost Basis Example
Say 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. Now you 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 owe capital gains tax on the $5,000 ($15 - $10 x 1,000 shares). (For further reading, see: Capital Gains Tax 101.)
What Is My Cost Basis on a Stock Investment?
How Stock Splits Affect Cost Basis
If the company splits its shares, this will affect your cost basis per share, but not the actual value of the original investment or the current investment. Continuing with the above example, suppose the company issues a 2:1 stock split where one old share gets you two new shares. You can calculate your cost basis per share in two ways:
- Take the original investment amount ($10,000) and divide it by the new number of shares you hold (2,000 shares) to arrive at the new per share cost basis ($10,000/2,000=$5.00).
- Take your previous cost basis per share ($10) and divide it by the split factor of 2:1 ($10.00/2 =$5.00). (For related reading, see: Understanding Stock Splits.)
Selling Shares From Multiple Investments
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 (and bring the total shares owned to 3000). There are several issues that come up when numerous investments have been made. The Internal Revenue Service (IRS) says if you can identify the shares that have been sold, their cost basis can be used. For example, if you sell the original 1,000 shares, your cost basis is $10.
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 oldest cost basis of $10, followed by 500 shares at the newer cost basis of $5. This would leave you with 1,500 shares at a cost basis of $5 to be sold at another time.
Cost Basis of Gifted or Inherited Shares
In the event the shares were given to you as a gift, your cost basis is the cost basis of the original holder 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 you as the inheritor is the current market price of the shares on the date of the original owner's death.
There are many factors that will affect your cost basis and eventually your taxes when you decide to sell. If your true cost basis is unclear, please consult a financial advisor, accountant or tax lawyer.
(For related reading, see: Know Your Stock Cost Basis.)