What is Cost Basis?

If you are thinking of doing our own taxes this year to save money there are some things you should know before you start, such as figuring out your capital gains’ cost basis. The cost basis is defined by the United States tax law, as the original cost of property adjusted for depreciation and is normally used to help calculate your capital gains and losses.

In the U.S., when property is sold the difference between the sale price and basis is either the income or loss reported at that time on U.S. tax returns. According to Publication 551 from the Department of Treasury IRS department, “basis is the amount of your investment in property for tax purposes; use the basis of property to figure depreciation, amortization, depletion, and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property.”

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 property as a gift, the basis is derived from a transferred or carryover basis. If you inherit a property, a stepped-up basis will apply which equals the fair market value. Finally, there is also adjusted basis that accounts for changes over time like home improves or market fluctuations and depreciation in value.

Cost basis is not a term solely restricted to the real estate market as it also applies to mutual funds. The IRS approves four basic methods for determining the basis for a mutual fund. According to their rules published in Publication 564, approved cost basis methods are specific share identification and the accounting method “first-in, first-out” (FIFO). Average basis methods include average cost single category (ACSC) and average cost double category (ACDC).