The cost basis is the amount you paid for a particular investment plus any fees and commissions paid to a broker, according to tax calculations. Often, the cost basis will simply be the original price you paid when acquiring the investment, such as stocks or funds, but in some cases, it becomes more complex. When you sell this investment, you need to know your cost basis to determine if you have a capital gain or loss.
How Cost Basis Works
Your cost basis – sometimes known simply as “basis” – is the amount you paid for the investment. The purpose of the cost basis is not to measure your investment returns. The cost basis is used to determine the amount you owe in taxes. When you sell this investment, you need to report your cost basis to the IRS, provided that the investment was in a taxable account. Your capital gain or loss is your selling price minus your cost basis. If you have a capital gain, you may be required to pay taxes on that money.
How to Calculate Cost Basis
Calculating cost basis can be challenging when you own stock or a mutual fund and have purchased multiple times at different prices. Let’s use an example to explain and illustrate the different methods you can use to calculate cost basis.
First In, First Out (FIFO)
The stocks you purchased first are treated as the first shares you sell. This is the default method for the IRS and the method most brokerage firms use automatically. You sell all the shares you purchased at $10 (totaling $1,000), plus 50 shares that you purchased at $12 (totaling $600). Your cost basis is $1,600.
Average Cost
The total cost of all your shares is divided by the number of shares you own, and then the average is used as your cost basis. This is the only option for mutual funds and certain dividend reinvestment plans (DRIPs). You cannot use the average cost method to calculate the cost basis for individual stocks. You take the total cost of buying all your shares, which is $5,300, and divide it by 400. Your cost basis becomes $13.25 per share. Multiply that by the number of shares you are selling, which is 150 shares. Your cost basis is $1,987.50.
Specific Identification
You specify to your broker the particular shares you wish to sell. You will need to notify your broker at the time of sale that you are using this method, so keep good records to document your basis. You select the shares you wish to sell. You might sell all the shares you bought at $16 (totaling $1,600), plus 50 shares that you bought at $15 (totaling $750). Your cost basis will be $2,350. However, because you held the shares bought at $16 for less than one year, you will be required to pay taxes on the short-term capital gain.
What This Means for Individual Investors
You only need to report your cost basis for investments you sell in taxable accounts. Cost basis does not matter for tax-exempt accounts, such as 401(k) plans and individual retirement accounts (IRAs) or 529 plans, because growth in these accounts occurs tax-free. Depending on the type of account, you may be taxed on the money when withdrawn as ordinary income, but you will not pay taxes on your capital gains.
Generally, the lower your cost basis, the greater your chances of making a capital gain. However, cost basis is not the only consideration when trying to minimize capital gains taxes. As illustrated in the example above, selling securities you have held for a year or more usually comes with a lower tax rate. When selling an investment you have held for less than a year, it is treated as a short-term capital gain and is taxed as ordinary income. If you are actively trading, holding investments for at least a year could save you significant tax dollars. Long-term capital gains tax rates range from 0% or 15% for most investors, with the highest earners not paying more than 20% (though there are some other exceptions where the tax rate can reach 28%).
Questions
Frequently Asked Questions (FAQs)
How do you determine the cost basis for an inherited home?
The cost basis for an inherited home is usually the fair market value at the date of the owner’s death. You can also use the fair market value at an alternate valuation date, but only if the executor has filed an estate tax return and elected to use the alternate valuation on the return.
What is the cost basis per share?
The cost basis per share is the amount you paid for each share after accounting for factors such as reinvested dividends, investment fees, and stock splits. The default method for calculating the cost basis per share is the first-in, first-out (FIFO) method. For mutual funds and some dividend reinvestment plans, you can use the average cost method.
This information has been provided by Robin Hartil, a certified financial writer and financial editor at The Balance. The article was reviewed by Anthony Battle, a financial editor at The Balance.
Leave a Reply