When Investing, What Is Your Cost Basis?

Understanding your cost basis is important for tracking an investment’s performance and managing tax obligations. Cost basis, also called tax basis, is the original value of an asset for tax purposes. This figure is the starting point for determining a capital gain or loss when you sell an investment, a required calculation for filing your annual tax return with the Internal Revenue Service (IRS).

Most brokerage firms track cost basis and report sales on Form 1099-B, which provides details needed for Schedule D (Capital Gains and Losses) on your tax return. Even with this help, understanding how cost basis is established and adjusted is important for making informed financial decisions. Keeping your own records allows you to verify broker information and is useful if you transfer assets between institutions.

Determining Your Initial Basis

How you acquire an asset dictates how its initial cost basis is determined. The primary methods are purchasing, inheritance, or receiving a gift, and each has a distinct set of rules for establishing this value.

Purchased Assets

For assets you buy, the initial basis is their total cost, including the purchase price plus any associated costs like commissions or brokerage fees. For example, if you purchase 100 shares of a stock at $50 per share and pay a $10 commission, your cost basis is $5,010.

Including these transactional costs increases your basis, which reduces your taxable capital gain when you sell the asset. Any fees incurred at the time of purchase should be recorded and added to your initial cost.

Inherited Assets

When you inherit an asset, its basis is determined by a “stepped-up basis” rule. The cost basis is adjusted to the fair market value (FMV) of the asset on the date of the original owner’s death. This provision means any appreciation during the decedent’s lifetime is not subject to capital gains tax for the heir.

For instance, if your grandfather bought stock for $1,000 and it was worth $50,000 on the day he passed away, your cost basis becomes $50,000. If you sold it immediately for that price, you would have no taxable gain. The executor of an estate may sometimes choose an alternate valuation date, which is six months after the date of death.

Gifted Assets

When you receive an investment as a gift, you take on the donor’s original cost basis, a concept known as “carryover basis.” For example, if a friend bought a stock for $200 and gives it to you when it is worth $1,000, your basis is the original $200.

If you later sell that stock for $1,200, your taxable gain would be $1,000. It is important to obtain the original purchase records from the person who gave you the investment.

How Basis Changes Over Time

Your initial cost basis is not static and can change while you own an investment. Certain events require you to adjust your basis up or down, which is necessary for accurately calculating your gain or loss.

Increases to Basis

Reinvesting dividends is a common event that increases your cost basis. When you use dividends to automatically purchase more shares, the amount of the reinvested dividend is added to your total cost basis because you already paid income tax on it.

For example, if you own shares with a $2,000 basis and reinvest a $100 dividend, your new adjusted basis becomes $2,100. Failing to account for this increase would cause you to overstate your capital gain. Any commissions paid on these reinvestments also increase your basis.

Decreases to Basis

Some events can decrease your basis. A “return of capital” is a distribution that is not a dividend but is treated as the company returning a portion of your original investment. This distribution reduces your cost basis by the same amount.

A stock split also affects your basis. In a 2-for-1 split, you receive two shares for every one you owned, but your total investment value and total basis remain the same. This reduces your per-share basis. If you owned 50 shares with a total basis of $5,000 ($100 per share), a 2-for-1 split would leave you with 100 shares and a new per-share basis of $50.

Calculating Your Gain or Loss

Once you sell an investment, you must calculate your capital gain or loss to determine your tax liability. The formula is: Sale Proceeds – Adjusted Basis = Capital Gain or Loss. Sale proceeds are the total amount received from the sale, minus commissions, while the adjusted basis is your initial basis after all adjustments.

For example, you bought 100 shares for $2,000, including a $10 commission, for an initial basis of $2,010. You reinvested $300 in dividends, increasing your adjusted basis to $2,310. You then sell all shares for $5,000 and pay a $10 sales commission, making your net proceeds $4,990.

Your taxable gain is $4,990 – $2,310 = $2,680. The length of time you held the investment determines if it is taxed at long-term or short-term capital gains rates.

Identifying Specific Shares Sold

If you purchase shares of the same security at different times and prices, you must identify which specific shares are being sold when you sell only a portion of your holdings. The accounting method you choose directly impacts the amount of capital gain or loss you realize from the sale.

FIFO (First-In, First-Out)

The default method used by brokers and the IRS is First-In, First-Out (FIFO). This method assumes that the first shares you purchased are the first ones you sell. In a rising market, using FIFO often results in a larger taxable gain because the oldest shares typically have the lowest cost basis.

For example, assume you bought 100 shares of a stock at $50 and a year later bought another 100 shares at $70. If you sell 100 shares when the price is $80, the FIFO method would use the $50 basis from the first purchase, resulting in a capital gain of $3,000.

Specific Share Identification

An alternative to FIFO is the specific share identification method. This approach allows you to choose which specific lot of shares you want to sell, giving you greater control over your tax outcome. You must instruct your broker which shares to sell at the time of the sale.

Using the previous example, you could instruct your broker to sell the 100 shares purchased at $70. By selling this higher-basis lot, your capital gain would be only $1,000. This strategy is useful for tax-loss harvesting or managing your income levels for a given year.