What Is Cost Basis?
Written by
John Csiszar
Edited by
Nupur Gambhir
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Cost basis is the original purchase price you paid for an asset. For example, if you bought a stock for $50, that is your cost basis. You need to know your cost basis so that if you sell an asset, you can determine the amount of gain that you’ve earned. This is particularly important for tax purposes. For example, if you sold that same stock for $90 per share, you’d have a gain of $40 per share.
In most cases, the concept of cost basis is relatively straightforward. However, you may have to make certain adjustments to your cost basis in order to accurately capture your potentially taxable gain. Here’s all you’ll need to know about what cost basis is, how you can calculate it, and why it matters to your financial life.
What is cost basis?
Cost basis is the original value of an investment or asset. Its primary use is to calculate gains or losses, both for tax purposes and for investment return calculations.
For federal income taxation purposes, how the property in question was acquired determines the cost basis. There are several ways to acquire assets. For those who purchased their property, the basis equals the purchase price. If once received the asset as a gift, the basis is derived from a transferred or carryover basis. If you inherit an asset, a stepped-up basis will apply which equals the fair market value.
What’s important to note is that your cost basis in an asset can change over time due to a number of factors, even if you don’t personally buy or sell any more of it. Reinvested dividends, for example, are one of the most common reasons why cost basis adjusts. When you reinvest dividends, whether in a stock, mutual fund, or other investment, you are actually buying more shares of that asset at a new price. If you buy $1,000 shares of a stock at $30 and reinvest $10 in dividends at $40, for example, your total cost basis is now $1,010, and your average cost per share rises to $30.07.
Stock splits will also cause an adjustment to your cost basis. If you own 100 shares of a stock that you paid $50 for and it splits 2-1, you’ll now own 200 shares of a stock with an average cost basis of $25 per share. While the total amount you spent will remain the same, the per-share cost will be cut in half.
When calculating your cost basis, you should also add in any fees or commission you pay to acquire an asset. If you buy 100 shares of stock at $40 and pay a $50 commission to do it, your cost basis is $4,050, not $4,000.
Why is cost basis important?
Cost basis is important because it has a direct impact on the capital gains taxes that you pay. Ultimately, the difference between the price you pay for an asset and the price you sell it at is the amount of your gain. Depending on what type of asset it is, how long you’ve held it and what type of account it is in, you may have to pay varying levels of tax on that gain.
If you sell an asset for less than you pay for it, you’ll have a capital loss. While this isn’t a situation most investors want to find themselves in, you can use losses to offset capital gains. This makes knowing your cost basis critical for making informed selling decisions.
Your cost basis can also play an important role in terms of your overall financial planning, including estate transfers and gifts. As you’ll see below, inherited assets and gifted ones carry different rules in terms of cost basis, and the distinction is important to know.
How To Calculate Cost Basis
Basic Formula
The basic formula for calculating cost basis is as follow:
- Purchase price + commissions/fees + adjustments = cost basis.
For example, say that you buy 100 shares of Intel (INTC) at $24 per share. You also pay $50 in commissions. This means your total cost basis is $2,450, or $24.50 per share.
Adjustments That Impact Cost Basis
Stock splits don’t change the total amount you pay for a stock, but they do adjust your per-share cost basis. For example, if you bought 100 shares of Apple (AAPL) at $230, your total cost basis is $23,000, or $230 per share, assuming no commissions or fees. If that stock splits two-for-one, you’ll then have 200 shares of Apple. However, you would have still paid $23,000 for those shares. This drops your cost basis per share to $115.
If you reinvest dividends, these will also change your cost basis. As each reinvested dividend is technically a purchase of more stock, you must add the cost to your original cost basis.
With real estate, certain capital improvements can also be added to your cost basis, reducing your potential taxable gain down the road. For example, if you remodel your kitchen, renovate your bathroom, add on a new room, build a deck or swimming pool and so on, the cost of these improvements can be added to your original purchase price. This can not only improve the value of your home but also reduce the taxes you might have to pay if you sell it.
Cost Basis for Different Asset Types
Although the concept of cost basis is the same for all assets, there are different ways you can use cost basis among different assets, along with different adjustments that you can make.
With stocks and mutual funds, for example, you’ll choose FIFO, LIFO, or specific identification at the time you sell the stock to minimize your tax obligation.
With real estate, you can use a host of expenses to increase your cost basis and reduce your ultimate tax liability, such as home improvements and selling expenses. But if you own rental real estate, you’ll also have to factor in deprecation, which can reduce your cost basis and increase your taxes if you sell at a gain.
Cryptocurrency is a relatively new asset class, and its taxation rules can get murky. However, at the end of the day, the IRS has ruled that cryptocurrency is property, not a currency. That means the same cost basis rules apply to crypto as to stocks, mutual funds, or other capital assets.
Here’s a deeper exploration of the importance of using various cost basis methods.
Cost Basis Methods and Their Tax Implications
When you sell shares, cost basis becomes a critical distinction. There are a number of ways you can account for your cost basis when you sell shares, particularly if you have bought an asset at numerous different times and prices. Here are the four basic cost basis methods and their tax implications.
First-In, First-Out (FIFO)
First-in, first-out means that the first shares you bought are the first shares that are sold. It often results in higher taxable gains because ideally assets appreciate in value over time, making the ones you bought first the most inexpensive. FIFO is the default method used by most financial services firms. If you don’t formally choose any other option, your trades will generally be reported using the FIFO method.
Last-In, First-Out (LIFO)
LIFO stands for “last-in, first-out,” making it the opposite of FIFO. Under this method, your newest shares are considered sold first. This can be a good strategy to use in a rising market, as it can reduce your taxable gains if your most recently purchased shares have a higher cost basis.
Specific Share Identification
Specific share identification allows investors to choose which shares to sell. This method requires detailed record-keeping but provides flexibility. For example, if you’re in a low tax bracket in a given year, you might have the flexibility to claim larger short-term capital gains, as you won’t have to pay as much tax on them. You might also use specific share identification to match your gains with your losses in any given year, offsetting your capital gains tax liability completely.
Average Cost Basis
The average cost basis method is often used with mutual funds and ETFs, where dividends are reinvested as often as monthly. Over time, this could amount to hundreds of individual transactions, making cost basis accounting a nightmare. In this scenario, the IRS allows investors to use the average cost basis method. To compute your average cost basis, you simply take the total value of your investment and divide it by the number of shares you have. This simplifies reporting but may not always be tax-efficient.
Special Cases and Cost Basis Adjustments
Inherited Assets and Step-Up in Basis
Beneficiaries of appreciated assets receive a step-up in cost basis based on the market value at the time of the inheritance. This can amount to a huge tax break. If someone buys a house for $100,000 and it appreciates to $500,000 at the time of their death, their heirs receive the home with a new cost basis of $500,000, not $100,000. This can dramatically reduce the tax burden for heirs.
Gifted Assets and Carryover Basis
Unlike inherited assets, gifted assets carry over the original owner’s cost basis. In the example above, if someone originally bought a $500,000 home for $100,000 and gifted it to someone else, they would take on the original cost basis of $100,000, not $500,000. This effectively transfers the tax liability from the giver to the recipient.
Tracking cost basis for gifts is essential for tax reporting. This is because it transfers to the recipient. You’ll also need to keep track of the market value of any gifts you make since they may be subject to gift taxes.
Stock Splits, Dividends, and Corporate Actions
Corporate actions can have an effect on your cost basis without any action on your part. For example, it is corporate boards that choose if they’re going to split their stock, not individual investors. But as an investor, you are the one who will have to report your adjusted cost basis if you sell your shares. Similarly, corporations are the ones who decide to pay dividends to their shareholders, but it’s the shareholders who will be responsible for tracking the new cost basis on any reinvested dividends.
Capital Gains Tax and Cost Basis
How Cost Basis Determines Taxable Gain or Loss
Cost basis is one of the two factors that determine the size of your capital gain or loss. The other is your sales price. As the formula states, your taxable gain or loss is computed by subtracting your cost basis from your sales price.
Here’s how a high or low cost basis can affect your taxes.
Imagine that you sell 100 shares of Microsoft (MSFT) at $400 per share. That will net you proceeds of $40,000, assuming no deductions for commissions or other fees. If you paid $350 per share for the stock, you’ll have a gain of $5,000, as you sold the shares for $40,000 and would have paid $35,000. But if you only paid $200 per share for the stock, your cost basis was a low $20,000. This means you’ll have a taxable gain of $20,000.
At a 20% long-term capital gains rate, you’d owe either $1,000 in taxes, if you had a higher cost basis, or $4,000, if you had a lower cost basis.
Short-Term vs. Long-Term Capital Gains
For tax purposes, capital gains are divided into short-term and long-term.
Short-term capital gains are assets held for up to one year. They are taxed at ordinary income rates.
Long-term capital gains are assets held for longer than one year. They have a special tax rate that is typically lower than ordinary income tax rates. In most cases, long-term capital gains are taxed at a 20% rate. Depending on your income and filing status, they may carry a 0% tax rate.
Tax-Loss Harvesting Strategies
The process of tax-loss harvesting involves offsetting capital gains with capital losses. For example, if you sell Nvidia stock and pocket a $5,000 gain, you can sell any of your losing positions and use them to offset your gain. Through careful tax planning, you can minimize the amount of capital gains taxes you have to pay every year. Additionally, the IRS allows you to offset up to $3,000 of ordinary income per year with capital losses as well.
If you do harvest your tax losses, be aware of the IRS wash sale rule. This states that you cannot buy or sell a “substantially identical security” to the one you are claiming a tax loss on within 30 days. For example, if you’re selling an S&P 500 index fund to take a loss and you immediately buy an S&P 500 index fund from a different company, the IRS will disallow your loss as a wash sale. You can still complete the transaction, you just aren’t allowed to claim the tax loss on it.
