How to Calculate Stock Basis for Tax Purposes

Stock basis is the total value of your investment in a security for tax purposes, which is used to determine your capital gain or loss when you sell your shares. Accurately calculating your basis ensures you report investment outcomes correctly to the IRS. The initial cost is subject to adjustments over the life of the investment, reflecting events like reinvested dividends or corporate actions.

Establishing Your Initial Cost Basis

The method you use to acquire stock dictates how you establish its initial cost basis. Shares can be acquired through a direct purchase, an inheritance, or as a gift, each with distinct rules.

Purchased Shares

When you buy shares, your initial basis is the price you paid plus any transaction costs, such as brokerage commissions. For example, if you purchased 100 shares at $50 per share and paid a $10 commission, your total cost basis is $5,010.

This initial cost is detailed on the trade confirmation statement from your brokerage. Since 2011, brokerage firms have been required to track and report the cost basis for equities to both the investor and the IRS on Form 1099-B after a sale.

Inherited Shares

The basis of inherited stock is its fair market value (FMV) on the date of the original owner’s death. This is known as a “stepped-up basis” because it adjusts from the original owner’s purchase price, meaning appreciation during the decedent’s lifetime is not subject to capital gains tax.

For instance, if stock bought for $1,000 was worth $50,000 on the day the owner died, your basis is $50,000. If you sell it for $51,000, you owe capital gains tax on only a $1,000 gain. The executor of the estate may choose an alternate valuation date, six months after the date of death. Any gain or loss you realize upon selling the inherited asset is automatically considered long-term.

Gifted Shares

The basis of gifted stock depends on whether you sell it for a gain or a loss, using the donor’s original basis and the stock’s fair market value (FMV) when the gift was made. If you sell for a profit, your basis is the same as the donor’s, known as a “carryover basis.” For example, if your parent gifts you stock they bought for $1,000 and you sell it for $5,000, your basis is $1,000, creating a $4,000 taxable gain.

If you sell the stock for a loss, your basis is the lesser of the donor’s original basis or the stock’s FMV on the gift date. If stock bought for $1,000 had an FMV of $700 when gifted, and you sell it for $500, your basis is $700, resulting in a $200 capital loss. If you sell the stock for a price between the donor’s basis and the FMV at the time of the gift, you report neither a gain nor a loss.

Common Adjustments to Stock Basis

After establishing your initial cost basis, certain events can change it, creating an “adjusted basis.” The most frequent adjustments include reinvested dividends, stock splits, and non-dividend distributions, also known as a return of capital.

Reinvested Dividends

In dividend reinvestment plans (DRIPs), cash dividends automatically purchase more shares. These dividends are taxable income in the year received, and the reinvested amount is added to your cost basis. For example, if a $100 dividend buys more shares, you report $100 as income and increase your basis by $100.

Failing to add reinvested dividends to your basis can lead to double taxation when you sell. Brokerage firms report these reinvestments on Form 1099-DIV, which you should use to track each purchase and maintain an accurate adjusted basis.

Stock Splits

A stock split increases a company’s number of outstanding shares. For example, in a 2-for-1 split, you receive two shares for every one you held. A split changes the number of shares you own and the price per share, but it does not alter your total cost basis.

Your original basis is reallocated across the new shares. If you owned 100 shares with a $5,000 basis ($50 per share), a 2-for-1 split leaves you with 200 shares and a total basis of $5,000, or $25 per share.

Return of Capital

A return of capital (ROC) is a non-taxable distribution that is not paid from a corporation’s earnings, but is instead a return of your original investment. An ROC reduces your cost basis in the stock. If your initial basis was $2,000 and you receive a $200 ROC, your adjusted basis becomes $1,800.

This is reported in Box 3 of Form 1099-DIV. Once your basis is reduced to zero by ROC distributions, any further distributions are taxed as a capital gain.

Identifying Shares and Special Rules When Selling

When selling shares purchased at different times and prices, you must identify which ones you are selling. The identification method you choose can affect your tax outcome, and IRS rules like the wash sale rule can impact your ability to claim losses.

Share Identification Methods

When selling a portion of your holdings, you can use one of two IRS-recognized accounting methods. The default method is First-In, First-Out (FIFO), where the first shares you bought are considered the first ones sold. This method may not be the most tax-efficient in a rising market, as your earliest shares likely have the lowest basis and would generate the highest capital gain.

The other method is Specific Identification, which allows you to choose which lot of shares to sell, giving you control over the tax outcome. To minimize taxable gains, you could sell shares bought at the highest price. To use this method, you must identify the specific shares to your broker when you sell.

The Wash Sale Rule

The wash sale rule prevents investors from claiming a capital loss if they acquire “substantially identical” securities within a 61-day period (30 days before the sale, the day of the sale, and 30 days after). The rule applies to stocks, bonds, and options and extends to purchases made by a spouse or a controlled corporation.

If a transaction is a wash sale, the loss is disallowed for the current tax year. The disallowed loss is then added to the cost basis of the new, replacement shares. For example, if you sell stock for a $500 loss and buy it back 15 days later, the $500 loss is disallowed and added to the basis of the new purchase.