What Does Cost Basis Mean in Stocks?

Cost basis represents the original value of an investment for tax purposes. This figure is the starting point for determining profit or loss when you sell an asset, such as shares of stock. The primary function of cost basis is to calculate capital gains or losses, which is the difference between what you paid for an asset and what you sold it for. Accurate tracking ensures you report the correct amount to the Internal Revenue Service (IRS).

Calculating Your Initial Cost Basis

The initial cost basis of a stock is calculated by taking the total purchase price and adding any transaction costs associated with the acquisition. Transaction costs include items like brokerage commissions and any Securities and Exchange Commission (SEC) fees. These costs are added to the share price to form the total investment value.

For example, an investor buys 100 shares of a company at $50 per share, resulting in a total share cost of $5,000. If the brokerage charged a $10 commission for the trade, the investor must add the transaction cost, making the total cost basis $5,010. This adjusted figure is the official starting point for tax calculations. This initial calculation is documented on the trade confirmation statement provided by the brokerage firm.

Events That Adjust Your Cost Basis

The initial cost basis of a stock is not static and can be altered by several events during the holding period. One of the most common adjustments comes from reinvested dividends. When an investor chooses to automatically reinvest dividends, those funds are used to purchase additional shares. Each reinvestment acts as a new purchase, increasing the total cost basis. For instance, if you receive a $100 dividend and it is used to buy more shares, your total basis increases by $100.

Corporate actions such as stock splits and reverse stock splits also modify your per-share cost basis. In a 2-for-1 stock split, an investor who owned 100 shares at a basis of $50 per share ($5,000 total) would now own 200 shares. The total basis remains $5,000, but the per-share basis is halved to $25. Conversely, in a 1-for-2 reverse split, that same investor would end up with 50 shares, and the per-share basis would double to $100.

A “wash sale” also impacts cost basis. The wash sale rule prevents investors from claiming a loss on a security if they buy the same or a “substantially identical” security within 30 days before or after the sale. If a loss is disallowed under this rule, that loss amount is added to the cost basis of the newly acquired replacement shares.

Special Acquisition Scenarios

The method of acquiring stocks can significantly alter how the cost basis is determined. For inherited stocks, the beneficiary’s cost basis is “stepped-up” or “stepped-down” to the fair market value of the security on the date of the original owner’s death. For example, if an individual inherits stock valued at $150 per share on the date of death, their basis is $150, regardless of whether the original owner paid $10 per share.

When stocks are received as a gift, the rules follow a “carryover basis” principle. The recipient of the gift takes on the donor’s original cost basis. If the person who gifted the stock originally paid $20 per share, the recipient’s cost basis is also $20 per share. This means the recipient will be responsible for the capital gains tax on all appreciation since the original purchase when they eventually sell the stock.

Choosing a Cost Basis Method

When an investor sells a portion of their holdings in a stock that was acquired at different times and prices, they must identify which specific shares were sold. The IRS permits several accounting methods for this purpose, and the choice can affect the amount of capital gain or loss reported. The default method used by most brokerage firms is First-In, First-Out (FIFO). Under FIFO, it is assumed that the first shares purchased are the first ones sold.

An alternative to FIFO is the Specific Share Identification (Spec ID) method. This approach allows an investor to choose precisely which lot of shares to sell. For example, if an investor wants to minimize their tax liability, they might choose to sell the shares that were purchased at the highest price, thereby realizing a smaller gain or a larger loss. This method requires careful record-keeping and communication with the brokerage at the time of the sale.

A third method, the Average Cost method, is primarily used for mutual funds and certain dividend reinvestment plans. With this method, the total cost of all shares is divided by the total number of shares owned to arrive at an average cost per share. Once an investor elects to use the average cost method for a particular fund, they must continue to use it for that investment.

Reporting Cost Basis on Tax Forms

The process of reporting cost basis for tax purposes involves specific forms that document investment sales. Brokerage firms are required to issue Form 1099-B to investors who have sold securities during the tax year. This form details the proceeds from sales and, for “covered” securities (generally those acquired after 2011), it also reports the cost basis to both the investor and the IRS.

The information from Form 1099-B is then used to complete IRS Form 8949, Sales and Other Dispositions of Capital Assets. This form is where individual sales transactions are listed, including the description of the property, dates of acquisition and sale, sales price, and cost basis. If the basis reported by the broker on Form 1099-B is incorrect, or if it is not provided for noncovered securities, Form 8949 is where the taxpayer makes the necessary corrections.

Finally, the totals from Form 8949 are transferred to Schedule D, Capital Gains and Losses. Schedule D summarizes the short-term and long-term capital gains and losses from all of a taxpayer’s Form 8949 entries. The net gain or loss calculated on Schedule D then flows to the main Form 1040, impacting the individual’s overall tax liability for the year.