How to Calculate Cost Basis for Tax Purposes

Cost basis represents the original value of an asset for tax purposes, establishing the starting point for measuring financial outcomes. When an asset is sold, the difference between the sale price and its cost basis determines the capital gain or loss for tax reporting.

Determining Your Initial Cost Basis

An asset’s initial cost basis is its total acquisition cost, including the purchase price plus any associated transaction expenses. This figure serves as the baseline before any future adjustments, and its components can vary depending on the asset type.

For securities such as stocks, bonds, or mutual funds, the initial cost basis is the price paid for the securities combined with any commissions or fees incurred during the purchase. For example, if an individual buys 100 shares of a company at $50 per share and pays a $10 commission, the total purchase cost is $5,010. This amount, not just the $5,000 value of the shares, becomes the starting basis.

When purchasing real estate, the initial cost basis includes more than just the contract price, adding a variety of settlement fees and closing costs paid by the buyer. These can encompass expenses like abstract fees, legal services, recording fees, land surveys, transfer taxes, and owner’s title insurance. However, costs like points paid to obtain a mortgage, ongoing property taxes, or homeowner’s insurance premiums are not added to the property’s basis.

Adjustments That Change Your Cost Basis

The cost basis of an asset is not static and can be altered by various events. These adjustments, which can either increase or decrease the original basis, must be tracked. The resulting adjusted basis reflects the total investment in an asset over its holding period.

Certain events will increase an asset’s basis, reflecting an additional investment. When dividends or capital gains from a mutual fund or stock are automatically reinvested to buy more shares, the value of these new shares is added to the total cost basis. For real estate, the cost of capital improvements increases the property’s basis. A capital improvement adds value to the property or prolongs its life, such as adding a new room, as opposed to a simple repair.

Conversely, some events will decrease an asset’s basis. A return of capital is a distribution from a corporation that is not paid out of its earnings and profits; it is a return of the investor’s original investment and reduces the stock’s cost basis. This information is reported on Form 1099-DIV. For rental or business real estate, the basis is reduced by any depreciation deductions claimed.

Other financial events can alter the per-share basis without changing the total basis. A stock split, for instance, changes the number of shares an investor owns but not the total value of their investment. If an investor holds 100 shares with a total basis of $1,000 and the company declares a 2-for-1 stock split, the investor will then own 200 shares. The total cost basis remains $1,000, but the basis per share is reduced from $10 to $5.

Cost Basis Calculation Methods for Securities

When an investor sells only a portion of their holdings in a specific security, they must use a recognized accounting method to determine which shares were sold. The IRS provides several methods for this purpose, each with different tax implications. The method selected can influence an investor’s tax liability for the year of the sale.

The First-In, First-Out (FIFO) method assumes that the first shares purchased are the first ones sold. This is often the simplest method to apply as it follows a chronological order. If a taxpayer cannot adequately identify which shares were sold, the IRS requires using the FIFO method, and many brokerage firms use it as their default. Using FIFO for a partial sale means selling the oldest shares first, which often have the lowest basis and could result in a larger capital gain.

The Specific Share Identification (Specific ID) method allows an investor to choose precisely which lot of shares to sell at the time of the transaction. To use this method, the investor must instruct their broker which specific shares to sell. This provides the flexibility to manage tax outcomes, for instance, by selling shares with the highest cost basis to minimize a taxable gain.

For mutual fund investors, the Average Cost method is a common option. This involves calculating the average basis for all shares held in the fund by dividing the total cost of all shares by the total number of shares owned. When shares are sold, this average cost per share is used to determine the basis of the sold shares. Once an investor makes a sale using this method, the decision becomes binding for those shares.

Special Situations for Acquiring Assets

The rules for determining cost basis differ when an asset is acquired through inheritance or as a gift rather than a direct purchase. In these scenarios, the basis is not determined by the original purchase price paid by the previous owner. Instead, specific IRS regulations dictate how the new owner’s basis is established.

For inherited assets, the beneficiary’s cost basis is the Fair Market Value (FMV) of the asset on the date of the original owner’s death. This is referred to as a “stepped-up” basis, as the value is often higher than the decedent’s original purchase price. The FMV for a stock is its market price on that day, while for real estate, it is determined by a professional appraisal. This rule allows appreciation during the decedent’s lifetime to escape capital gains taxation.

The rules for gifted assets depend on whether the asset is later sold for a gain or a loss. If the gifted asset is sold for a gain, the recipient’s basis is the same as the donor’s adjusted basis at the time of the gift, a concept known as “carryover basis.” This means the recipient also takes on the tax liability for any appreciation.

A different rule applies if the gifted asset is sold for a loss. In this case, the basis is the lesser of either the donor’s adjusted basis or the asset’s FMV at the time the gift was made. This “dual-basis” rule prevents the transfer of a built-in loss from the donor to the recipient. If the asset is sold for a price between the donor’s basis and the lower FMV, no gain or loss is recognized.