What is Basis
Basis has many meanings in finance, but most frequently refers to the difference between the price and expenses in a transaction when calculating taxes. Such usage relates to "cost basis" or "tax basis," and is used when capital gains (or losses) are calculated for income tax filings. Another definition is that basis is the variation between the spot price of a deliverable commodity and the relative price of the futures contract for the same actual that has the shortest duration until maturity. "Basis" may also be used in reference to securities transactions; a security's basis is its purchase price after commissions or other expenses.
Breaking Down Basis
Since the term basis can refer to different ideas in the finance and investment world, an example of each may help clarify what this term means in each context.
Basis in the Futures Market
In the futures market, the difference between the cash price of the commodity and the futures price is the basis. It is a crucial concept for portfolio managers and traders because this relationship between cash and futures prices affects the value of the contracts used in hedging. As there are gaps between spot and relative price until expiry of the nearest contract, the basis is not necessarily accurate. In addition to the deviations created because of the time gap between expiry of the futures contract and the spot commodity, product quality, location of delivery and the actuals may also vary. In general, the basis is used by investors to gauge the profitability of delivery of cash or the actual, and is also used to search for arbitrage opportunities. As an example, assume the spot price for crude oil is $50 per barrel and the futures price for crude oil deliverable in two months' time is $54. The basis is $4, or $54 - $50.
Basis as Cost
A security's basis is the purchase price after commissions or other expenses. It is also known as cost basis or tax basis. This figure is used to calculate capital gains or losses when a security is eventually sold. For example, assume you purchase 1,000 shares of a stock for $7 per share. Your cost basis is equal to the total purchase price, or $7,000.
In the context of IRAs, basis originates from nondeductible IRA contributions and rollover of after-tax amounts. Earnings on these amounts are tax-deferred, similar to earnings on deductible contributions and rollover of pretax amounts. Distributions of amounts representing basis in an IRA are tax-free. However, to ensure this tax-free treatment is realized, the taxpayer must file IRS Form 8606 for any year that basis is added to the IRA and for any year that distributions are made from any of the individual's traditional, SEP and/or SIMPLE IRAs. Failure to file Form 8606 may result in double taxation of these amounts and an IRS-assessed penalty of $50. For example, assume your IRA is worth $100,000, of which $20,000 was nondeductible contributions or 20% of the total. This ratio of basis applies to withdrawals, so if you withdraw $40,000, 20% or $8,000 is considered basis and is not taxed.