The cost basis of any investment is the original value of an asset adjusted for stock splits, dividends, and capital distributions. It is used to calculate the capital gain or loss on an investment after it's been sold, for tax purposes.
key takeaways
- Calculating the cost basis of an investment indicates the capital gain or loss on it—and thus, how much tax may be owed.
- A variety of factors affect the cost basis of a stock, including commissions, stock splits, capital distributions, and dividends.
- Several issues that come up when numerous investments in the same stock have been made over time and at different price points; if you can't identify the exact shares sold, you use the first in, first out (FIFO) accounting method.
What Is the Cost Basis?
At the most basic level, the cost basis of an asset or security is the total amount invested in it, plus any commissions 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.
However, the actual calculation of cost basis can be complicated due to the many changes occurring in the market and to the security, such as stock splits and takeovers. For the sake of simplicity, we will not include commissions in the following examples, but this can be done by adding the commission amount to the investment amount ($10,000 + $100 in commissions = $10,100 cost basis).
Cost Basis Example
Say you invested $10,000 in ABC Inc., which bought you 1,000 shares in the company. The cost basis of the investment is $10,000, but it is more often expressed in terms of a per-share basis, so for this investment, it would be $10 ($10,000/1,000). After a year has passed, the value of the stock has risen to $15 per share, and you decide to sell. Now you need to know your cost basis to calculate the tax amount for which you are liable. In this case, it's pretty straightforward: Your investment has risen to $15,000 from $10,000, so you owe capital gains tax on the $5,000 ($15 - $10 x 1,000 shares).
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).
- Take your previous cost basis per share ($10) and divide it by the split factor of 2:1 ($10.00/2 = $5).
Selling Shares From Multiple Investments
However, if the company's share price has fallen to $5 and you want to invest another $10,000 (2,000 shares) at this discounted price, this will change the total cost basis of your investment in that company (and bring the total shares owned to 3,000). There are several issues that come up when numerous investments have been made over time and at different price points. The Internal Revenue Service (IRS) says if you can identify the shares that have been sold, their cost basis can be used. For example, if you sell the original 1,000 shares, your cost basis is $10.
If you can't make this identification, the IRS says you need to use the first in, first out (FIFO) method. Therefore, if you were to sell 1,500 shares, the first 1,000 shares would be based on the oldest cost basis of $10, followed by 500 shares at the newer cost basis of $5. This would leave you with 1,500 shares at a cost basis of $5 to be sold at another time.
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.
