Cost basis is the amount of money you spent to buy an asset. This amount usually includes the purchase price, fees, reinvestments, and commissions. Cost basis must be reported on your taxes. Determining cost basis can help you see how much you are making or losing with your investments, and might help you save money on taxes.
Come tax season, you may have to provide information about your investments. When reporting on investments for tax purposes, knowing your investments’ cost basis will be essential.
Simply put, the cost basis is the total amount you spent to obtain an asset. The cost usually includes the original purchase price and any fees paid to own it. Assets include real estate, stocks, inheritance, and more.
It’s important to understand cost basis for a couple of reasons. First, you have to report it on your taxes. Second, the way you report it could mean paying less in taxes. Knowing what cost basis is and how to track it can help you make the most out of your investments and save money in the long run. So keep reading to learn more about cost basis and what the most efficient way to calculate it is.
What is cost basis?
Cost basis is how much you originally paid to own an asset or investment, and any fees you paid to obtain that asset. Fees for an asset include any reinvestments, capital gain distributions, commissions, and more. Cost basis is used to determine how much you gained or lost when selling that asset.
Cost basis helps investors see if they will make a profit from selling their investment. This is known as capital gain.
Short-term capital gain is any profit earned from an asset sold within one year of purchase. Long-term capital gain is any profit earned from selling the asset after at least a year of ownership.
Cost basis can also help investors determine whether their investment has resulted in a loss of money. This is called a capital loss.
Similar to capital gains, a short-term capital loss is when you lose money upon selling an asset within a year of purchase. A long-term capital loss is the loss of money when selling an asset after at least a year of ownership.
The importance of cost basis
Cost basis is important for a couple of reasons. The first is for tax purposes. You must accurately report your cost basis to the IRS in your taxes. Short-term capital gains tax rates can be as high as normal income rates, while long-term investments could have a lower tax rate.
The second reason why cost basis is important is because it helps monitor how profitable your asset is. Cost basis shows if you’re steadily losing money instead of gaining money. If you’re losing more with your investment than you are gaining, it may be time to change directions.
Examples of cost basis
- Dividends. The cost basis of reinvested dividends is the price paid for the new shares.
- Gifts. The cost basis of a gifted asset is the amount the purchaser spent on the item. If the gift is stock and it is trading for less than what it was purchased for, the cost basis is the fair market value at the time the gift was given.
- Inheritance. The cost basis for inheritance is the fair market value of the asset at the time of the person’s death.
- Mergers or stock splits. The total cost basis generally does not change in a merger or stock split, but the cost basis per share could.
- Mutual funds. The cost basis of mutual funds is the original purchase price, plus the broker and shareholder fees.
- Purchasing stocks. The cost basis for buying stock is the purchase price of the shares plus the commission fees paid to the broker.
- Real estate. The cost basis for real estate is the property price and any capital gains from the renovation of the property.
Cost basis method
Determining cost basis is necessary for tax reasons. There are a few different methods you can use for calculating cost basis with investments and stocks, and it’s easier than it sounds. Here are a few different ways approved by the IRS to calculate cost basis:
Average cost method
The average cost method is frequently used for mutual funds. To find the cost basis for your mutual fund, you would take all the shares you’ve purchased and divide them by the number of shares you have.
For example:Kierah purchased five shares for $50 and ten shares for $100. Kierah’s cost basis would be the total cost spent on the shares ($1,250) divided by the total number of shares owned (15). This would come out to $83.
First in, first-out (FIFO)
The FIFO cost basis method is usually used when you buy multiple shares from the same company at different times. When selling stocks, the company would sell them back in the same order they were purchased.
In the case of FIFO, the cost basis would be the number of shares sold from the first purchase times the price, then added to the amount sold from the second purchase times that price.
Here’s an example:Jeremy bought 200 shares from X for $20 each in March 2016. In August of 2016, he bought 100 more shares from X for $10. Now he is selling 240 of his shares.
Using the FIFO method, the formula Jeremy would use is (200 x 20) + (40 x 10). This would make his cost basis $4,400.
This method allows companies to pick and choose which stocks to sell based on when they were bought and their original price. This method is useful as it could help you lower your tax payments.
Example:Chris bought 20 shares from Y Company for $20 in January of 2019. In March of 2019, Chris purchased 40 more shares from Y Company for $30. In December of 2019, he decides to sell 30 shares.
With the specific identification method, Chris could choose to use the more expensive shares for his cost basis. So he could sell the 30 shares from the stocks purchased in March. Chris would owe less in taxes using the specific identification method than he would if he used FIFO.
Which method should I use?
Choosing which method to use will depend on your asset, individual needs, and current financial situation. Tax experts can be a valuable resource for you. They can help you determine which cost basis method to use. But here’s a general overview of when to use each method.
|Method||When to use|
|FIFO||This method is particularly helpful if you don’t want to (or haven’t) kept track of when you purchased and sold shares. FIFO can be used for most investments, except mutual funds.|
|Average cost method||This method is used for mutual funds, but it can only be used if you did not sell all the shares in the fund. One drawback of using this method is that any shares that exist when this method is first used are subject to the same method in the future.|
|Specific identification||Also similar to FIFO, the specific identification method can be used for most investments. This method does require you to keep close track of when you bought and sold your assets. Though tedious, it could save you a lot in taxes. If you’ve been keeping track of when you bought and sold your investments, specific identification could be the best cost basis method for you.|
If doing this yourself sounds complicated, or if you just don’t have the time for it, the right tax preparation assistance could make things a lot easier.
What causes gain or loss?
The following instances can result in capital gains or a capital loss:
Capital improvements are any changes made to the investment that increase its value. For example, finishing a basement or upgrading appliances can increase the value of your home. This is a capital improvement.
Depreciation deductions are anything that deducts value from the investment. For instance, an outdated water heater or faulty roof can lower the value of your home. This is considered a deprecation deduction.
How the asset was obtained
The asset’s cost basis is also affected by how you got it. If you purchase it yourself, the cost basis is the amount you paid to own it. On the other hand, if you inherited it, the cost basis is the value at the time of the original owner’s death. In the case of gifts, the cost basis transfers from the original owner to you. So in this instance, the cost base is the purchase price paid by the original owner.
Publicly traded companies sometimes split available stocks. For instance, a company may do a 2-for-1 split, causing every share outstanding to become two. This is called a stock split. Stock splits can have a dramatic effect on any investments you have in stocks.
Though a stock split should not greatly affect the value of your total set of a company’s stocks, it will reduce the value of individual shares. You will own more shares worth less per share, and you will need to adjust how you determine the cost basis for any shares you sell to account for the increase in share count.
What to report to the IRS
Again, a tax professional will be a valuable resource when determining what to report to the IRS, but the following are investments they specifically require you to report:
- Equities such as stocks or REITs (real estate investment trusts) that were received on or after January 1, 2011.
- ETFs, mutual funds, and dividend reinvestment plans acquired on or after January 1, 2012.
- Most fixed income securities, bonds, and other specified securities obtained on or after January 1, 2014.
Have you already failed to report one or more investments you were required to and ended up owing the IRS more than you can afford to pay all at once? If so, it may be time to seek our professional tax relief assistance.
What is the difference between basis and cost basis?
Basis is the cost of an investment at the time of purchase. The cost basis is how much you spend to buy that investment. This includes the purchase price and additional fees or commission needed to obtain the investment.
How does IRS verify cost basis?
Law requires that brokerage firms report cost basis to the IRS when an investment is sold. You are also required to report cost basis in your tax return.
How do I determine the cost basis of a stock?
Take the original purchase price and divide it by the number of shares you own. So, if the original purchase price is $15,000 and you own 500 shares, the cost basis would be $30.
Note that this method accounts for any stock splits since it divides the original purchase price by the current number of shares. No matter how many splits your stocks have gone through, this method will give you the correct cost basis for the shares you currently own.
How do you report cost basis on taxes?
Fill out Form 8949 to report the cost basis on your taxes.
- Cost basis is the original purchase price you paid for an asset plus any additional fees.
- You must report your cost basis to the IRS in your tax return.
- Cost basis can be calculated using FIFO, specific identification, or average cost method.
- Stock splits or capital improvements are two things that can affect the value of your asset.
If in doubt, consult a professional
If you’re still unsure which cost basis method to use, or even if you want to double-check your calculations, talk to a tax expert. You can also do it yourself with tax preparation software. Check out SuperMoney’s reviews and comparisons of tax preparation firms to see which one provides the best option for you.
View Article Sources
- 2021 Instructions for Form 1120-REIT — IRS
- Cost basis accounting: Frequently asked questions — Putnam Investments
- Cost Basis Basics—Here’s What You Need to Know — FINRA
- Guide To Calculating Cost Basis For Tax Savings — Novel Investor
- Relevant articles by Charles Schwab, H&R Block, and other marketplace investing and wealth management sites — Various
- What Does Cost Basis Mean? (Plus How To Calculate) — Indeed
- Beginner’s Guide to Investing — SuperMoney
- Best Tax Preparation Firms — SuperMoney
- The Best Tax Relief Companies — SuperMoney
- Understanding Crypto And Capital Gains Taxes — SuperMoney
- What Happens If You Inherit a House With a Mortgage? — SuperMoney
Camilla has a background in journalism and business communications. She specializes in writing complex information in understandable ways. She has written on a variety of topics including money, science, personal finance, politics, and more. Her work has been published in the HuffPost, KSL.com, Deseret News, and more.