If you were to sell an asset or investment, do you know what your cost basis would be? Learn more about this important value and why it matters when it comes time to file your taxes.
What Is Cost Basis?
At its simplest, cost basis is the original price or value of an asset or investment, such as stocks, real estate, and even insurance policies. This number is used when calculating capital gains (the selling price minus the purchase price) and is key to understanding your tax responsibilities.
However, the initial price is only one component of your total cost basis. You must also include any expenses involved in purchasing the asset or investment. For example, if you purchased a stock, you would add up the share price and any commissions or fees.
To complicate things further, the cost basis adjusts over time to account for different financial developments, such as stock splits and return of capital distributions.
Calculating Cost Basis
While there are a handful of different methods for calculating your cost basis, the IRS and most brokerages default to the First In, First Out (FIFO) method unless you specify which method you’d prefer to use.
Using the FIFO approach, let’s say an investor purchases 10 shares of X for $1,000 ($100 per share) and then later purchases 10 additional shares of X for $500 ($50 per share). If the investor goes on to sell 15 shares, the cost basis for the first 10 shares would be $1,000 (the cost of the first shares “in”). The remaining 5 shares would then have a cost basis of $250. The total cost basis would be $1,250.
Other common methods for calculating cost basis include:
Average cost: The average cost method involves taking an average of the purchase price of all owned shares. This is most commonly used for mutual funds.
Specific shares: This method gives you the flexibility to choose which shares to sell, which can be beneficial if you’re looking to minimize the tax implications of your sale.
There is no “right” method. Each one has its benefits and its downsides. To select the method that best aligns with your individual financial situation, consider working with a trusted wealth advisor.
Why Does It Matter?
Your brokerage is required to report your cost basis to the IRS if the security was purchased after these dates:
- Equities acquired on or after January 1, 2011
- Mutual funds, ETFs, and dividend reinvestment plans acquired on or after January 1, 2012
- Other specified securities, including most fixed-income securities and options acquired on or after January 1, 2014
Prior to these dates, more responsibility was shouldered by the individual investor.
This cost basis information is imperative when making decisions about what to sell and which sales method to use (FIFO, LIFO, Average or specific shares). You’ll also need to know how long you’ve held the security. Anything held longer than 1 year gets preferential tax treatment.
Cost Basis Examples
Bankruptcies
If a company declares Chapter 7 bankruptcy, it no longer exists, and any shares become worthless. However, if the company files for Chapter 11 bankruptcy, the stock would still retain value, and the original cost basis would carry over.
Mergers
If one company merges with another, the cost basis usually remains the same, but if the company receives new shares, the cost basis per share typically needs to be recalculated.
Inheritances
If a stock is inherited, the cost basis can be adjusted to the date of the benefactor’s death. If a stock is gifted, the cost basis will remain the original price on the day the gifter purchased the stock.
Stock splits
Declaring a stock split doesn’t impact your cost basis. The number of shares goes up, but the initial cost stays the same. Each share would simply have a lower individual price.
Get Expert Help With All Things Cost Basis
Whether you need help selecting the right method for you, calculating your cost basis, or keeping track of adjustments, we’re here to help with our comprehensive financial planning and tax services. To learn more about how we can support you, reach out today.
