What Is Cost Basis?
Cost basis is the original value of an asset for tax purposes, usually the purchase price, adjusted for stock splits, dividends, and return of capital distributions. This value is used to determine the capital gain, which is equal to the difference between the asset's cost basis and the current market value. The term can also be used to describe the difference between the cash price and the futures price of a given commodity.
Cost Basis Basics
Understanding Cost Basis
At the most basic level the cost basis of an investment is the total amount originally invested, plus any commissions or fees 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.
Using the correct cost basis, also referred to as the tax basis, is important especially if you reinvested dividends and capital gains distributions instead of taking the earnings in cash. Reinvesting distributions increases the tax basis of your investment, which you must account for to report a lower capital gain and therefore pay less tax. If you don't use the higher tax basis, you could end up paying taxes twice on the reinvested distributions. Determining the correct cost basis is also the first step when calculating gains and losses after a stock is sold.
Reinvesting dividends increase the cost basis of a stock because dividends are used to buy more shares.
The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where your assets are held. Many brokerage firms default to the average cost basis method. Investors can also choose from other methods including: first in first out (FIFO), last in first out (LIFO), high cost, low cost and more. Once a cost basis method is determined for a specific mutual fund it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections. 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 is to keep good records and simplify the investment strategy where possible.
- Cost basis is the original price that an asset was acquired, for tax purposes.
- Capital gains are computed by calculating the difference from the sale price to the cost basis.
- Several accounting methods exist to adjust the cost basis so that it is more favorable, but be careful to follow IRS guidelines.
Example of Cost Basis
For example, if 100 shares of a stock were purchased for $1,000 last year, with the first year of dividends amounting to $100 and second year dividends amounting to $200, all of which was reinvested, applicable tax law considers these reinvested earnings to be income. For tax calculation purposes, the adjusted cost basis when the stock is sold will be recorded at $1,300 instead of the original purchase price of $1,000. Thus, if the sale price is $1,500, the taxable gain would only be $200 ($1,500 - $1,300) instead of $500 ($1,500 - $1,000). If the cost basis is incorrectly recorded as $1,000, this results in a higher tax liability than would normally be due.
Cost Basis Comparisons
Cost basis comparison can be an important consideration. Assume that an investor made the following consecutive fund purchases in a taxable account: 1,500 shares at $20, 1,000 shares at $10 and 1,250 shares at $8. The investor’s average cost basis is calculated by dividing $50,000/3,750 shares. The average cost is $13.33.
Suppose the investor then sells 1,000 shares of the fund at $19. The investor would have a capital gain of $5,670 using the average cost basis method.
- Gain/loss using average cost basis: ($19 - $13.33) x 1,000 shares = $5,670
Results can vary significantly by cost basis.
- First in first out: ($19 - $20) x 1,000 shares = - $1,000
- Last in first out: ($19 - $8) x 1,000 = $11,000
- High cost: ($19 - $20) x 1,000 shares = - $1,000
- Low cost: ($19 - $8) x 1,000 = $11,000
In this case, the investor would be better off if they had selected the FIFO method or the high cost method to determine the cost basis prior to selling the shares. These methods would result in no tax on a loss of $1,000. With the average cost basis method, the investor must pay a capital gains tax on the gain of $5,670.
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.)
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.
Cost Basis and Futures Contracts
In regards to futures, the cost basis is the difference between a commodity’s local spot price and its associated futures price. For example, if particular corn futures contract happens to be trading at $3.50, while the current market price of the commodity today is $3.10, there is a 40-cent cost basis. If the reverse were true, with the future contract trading at $3.10 and the spot price being $3.50, the cost basis would be negative 40 cents, as a cost basis can be positive or negative depending on the prices involved.
The local spot price represents the prevailing price for the underlying asset, while the price listed in a futures contract refers to a rate that would be given at a specified point in the future. Futures prices vary from contract to contract depending on the month when they are set to expire.
As with other investment mechanism, the spot price fluctuates depending on current local market conditions. As the delivery date approaches, the price of futures and the spot price shift closer together.