What Is the Cost Basis Formula and How Is It Calculated?

Cost basis is your total financial investment in an asset for tax purposes. When you sell an asset, the capital gain or loss is the difference between the sale price and its cost basis. This gain or loss is reported to the Internal Revenue Service (IRS) to determine your tax liability. A higher cost basis reduces your taxable gain, while a lower basis increases it.

The General Cost Basis Calculation

The formula for an asset’s initial basis begins with the purchase price. You then add any costs associated with acquiring the asset, such as sales tax, freight charges, and installation or testing fees. This sum establishes the asset’s original cost basis.

An asset’s basis can change over time, resulting in an “adjusted basis.” The adjusted basis is calculated by taking the initial basis, adding the cost of capital improvements, and subtracting any decreases. For example, adding a new room to a building increases the basis. Common decreases to basis include depreciation deductions and insurance reimbursements for casualty or theft losses.

Calculating Basis for Securities

The cost basis for securities includes the purchase price plus transaction fees like brokerage commissions. When you sell a portion of a security acquired at different times and prices, the IRS requires a consistent accounting method to identify which shares were sold.

The default method is First-In, First-Out (FIFO), which assumes the first shares purchased are the first ones sold. While straightforward, FIFO may not be the most tax-efficient if early shares have a low basis. Alternatively, the Specific Identification method allows you to choose which specific shares to sell. This provides an opportunity to manage your tax outcome, for instance, by selling shares with a higher basis to realize a smaller gain, but this method requires meticulous record-keeping to track each share lot.

For mutual funds, you can also use the Average Cost method. This is calculated by dividing the total cost of all shares by the number of shares owned. This method simplifies calculations, especially for investors who regularly reinvest dividends. Once you choose this method for a fund, you must continue using it for all future sales from that fund.

Reinvested dividends and capital gains distributions increase your total cost basis because you are buying more shares. A stock split changes your per-share basis but not your total basis. For instance, after a 2-for-1 split, you will have double the shares, and the cost basis for each share will be halved.

The wash sale rule prevents you from claiming a loss on a security if you buy a “substantially identical” one within 30 days before or after the sale. The disallowed loss is not lost permanently; it is added to the cost basis of the new shares. This adjustment defers the tax loss until the replacement shares are eventually sold.

Determining Basis for Real Estate

The cost basis of real estate starts with the purchase price. You then add certain settlement fees and closing costs from your settlement statement that were necessary to acquire the property. Includable costs are:

• Abstract fees
• Charges for installing utility services
• Legal fees
• Recording fees
• Surveys
• Title insurance

Costs for obtaining a loan, like mortgage points or appraisal fees, are not added to the property’s basis.

The basis of real estate is increased by capital improvements, which are distinct from routine repairs. Capital improvements add value, prolong the property’s useful life, or adapt it to new uses. Examples include:

• Building an addition
• Finishing a basement
• Installing a new HVAC system
• Replacing the entire roof

Repairs, in contrast, keep the property in good operating condition but do not add to its value or prolong its life. The costs of repairs like painting a room or fixing a leak are not added to the basis. If the property is a rental, these repair expenses may be deductible in the year they occur.

For real estate used as a rental, depreciation deductions must be subtracted from the basis. The cumulative amount of depreciation claimed over the years reduces your cost basis. This reduction applies even if you did not claim a depreciation deduction you were entitled to take.

Basis for Inherited and Gifted Assets

When you inherit property, the asset’s basis is “stepped-up” to its fair market value (FMV) on the date of the original owner’s death. This rule means that any appreciation in the asset’s value during the decedent’s lifetime is not subject to capital gains tax.

An estate’s executor can elect an alternate valuation date, which is six months after the date of death. If this option is chosen, the basis becomes the FMV on that later date. This is usually done only if the estate’s assets have decreased in value, as this can reduce the overall estate tax liability.

For assets received as a gift, you take on the donor’s adjusted basis at the time of the gift, which is known as a “carryover basis.” This means you also inherit the built-in capital gain. Your taxable gain upon selling the asset will be based on the donor’s original investment.

An exception to the carryover basis rule applies if the asset’s FMV at the time of the gift is less than the donor’s adjusted basis. In this situation, a dual-basis rule is used. Your basis for calculating a future gain is the donor’s adjusted basis, but your basis for calculating a loss is the lower FMV from when you received the gift.

Required Documentation and Recordkeeping

Accurate records are necessary to substantiate your cost basis calculations. For real estate, keep the final closing statement from the purchase and detailed receipts and contracts for all capital improvements.

For securities, your records should include original trade confirmations showing the purchase price and commissions. While brokerage firms provide Form 1099-B after a sale, you should also keep your own records to track adjustments like reinvested dividends, which appear on year-end statements.

For inherited assets, documentation includes the estate tax return or an appraisal establishing the FMV at the date of death. If you receive a gift, obtain a statement from the donor detailing their adjusted basis and the FMV on the date of the transfer. These records serve as your primary evidence for the IRS and are necessary in the event of an audit.