What Is Publication 551?
IRS Publication 551, entitled Basis of Assets, is an informational document published by the Internal Revenue Service (IRS) that outlines how to determine the cost basis for investments, real estate and business assets. The cost basis is used to determine what amount of gain or loss is realized from a sale, and represents the original cost of the investment or property. It is also used to determine depreciation and amortization for a piece of property.
IRS Publication 551 can be found on the IRS website.
- IRS Publication 551 informs taxpayers how to obtain the cost basis of an asset or investment.
- Cost basis is the original value or purchase price of an asset or investment for tax purposes.
- Basis is used to calculate the capital gains tax rate, which is the difference between the asset's cost basis and current market value.
- The IRS requires the first-in, first-out (FIFO) method for calculating taxes and cost basis, meaning the oldest holdings are sold first for tax purposes.
Understanding IRS Publication 551
The cost basis for a piece of property is typically the purchase cost, however the basis may increase over time if the owner makes improvements to the property. For investments, such as stocks and bonds, the cost basis also includes trading fees.
For tax purposes, the method used by the Internal Revenue Service (IRS) is first-in, first-out (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.
Beginning in 2018, small businesses are not subject to the uniform capitalization rules if the average annual gross receipts are $25 million or less for the 3 preceding tax years and the business isn't a tax shelter. The uniform capitalization rules specify the costs you add to basis in certain circumstances. More information on establishing the cost basis for investments can be found in IRS Publication 550.
Tax Reporting Cost Basis
Although brokerage firms are required to report the price paid for taxable securities to the IRS, for some securities, such as those held for a long period of time or those transferred from another brokerage firm, the historical cost basis will need to be provided by the investor. All of which puts the onus of accurate cost basis reporting on investors.
Determining the initial cost basis of securities and financial assets for only one initial purchase is very straightforward. In reality, 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. With all of the various types of investments, including stocks, bonds, and options, calculating cost basis accurately for tax purposes, can get complicated.
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. The equity cost basis is the total cost to an investor; this amount includes the purchase price per share plus reinvested dividends and commissions. Equity cost basis is not only required to determine how much, if any, taxes need to be paid on an investment, but is critical in tracking the gains or losses on investment to make informed buy or sell decisions.