What Is Cost Basis And How Do You Calculate It?
Selling an asset generally comes with tax consequences. Determining the cost basis of that asset is imperative in determining your taxable amount.
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Stock Cost Basis Definition
Cost basis is the purchase price of a particular security plus any related costs. Over time, cost basis is also adjusted for stock dividends (or reinvestments), stock splits, and redistributions. A realized capital gain is calculated by subtracting the cost basis from the stock's sale price and an unrealized capital gain is calculated by subtracting cost basis from the current market price of the investment.
Capital gains can be short-term or long-term. Long-term capital gain refers to a security held for more than one year. The tax rates for long-term capital gains are usually lower than that of short-term gains. Short-term gains are taxed similar to ordinary income while long-term gains have their own tax rate.
Cost Basis and Taxation
Cost basis, as stated earlier, is the original price of an asset plus commission and fees. However, with every subsequent purchase of a particular asset, tracking its purchase date and transaction value becomes important.
Capital losses can be offset against capital gains. For instance, if an investor realizes a $2,000 short-term gain and a $1,000 short-term loss, they can subtract the loss against the gain, so that they are only taxed on $1,000.
How To Calculate Cost Basis
There are three commonly used methods for calculating the cost basis. These methods are approved by the IRS and include the following:
- First In, First Out (FIFO)
- Average Cost
- Specific Shares
Discover more about method below.
1. First In, First Out (FIFO)
The FIFO method is generally used when you've purchased shares of the same company at various points in time. FIFO stands for "first in, first out" and assumes that the shares sold are the ones that have been owned the longest.
2. Average Cost
The average cost method calculates cost by taking an average of the purchase price of all owned shares.
3. Specific Shares
As the name suggests, the method allows you to have flexibility in selecting which shares to sell.
Uses for Tracking Cost Basis
Tracking cost basis is important for tax-related purposes and performance calculation.
Buying Stock
When buying a stock, the cost basis is the commission fees paid to the broker along with the purchase price of the shares. That means if you bought 100 shares worth $20 and paid $150 to your broker, the cost basis will be $2,150.
(100 shares x $20 per share) + $150 to broker = $2,150
Mutual Fund Cost Basis
Mutual funds are also tracked in the same way as buying a specific stock. However, there are usually two broad-based expenses with mutual funds. The broker has ongoing fund management expenses and shareholder fees (one-time costs). The shareholder fees are typically part of the cost basis computation.
Dividends
For a stock that pays a dividend, the cost basis factors reinvestment or cash dividends or dividends issued in stock.
Calculating Cost Basis of Gifted Stock
The cost basis for a gifted stock is equal to what the original owner paid for it. If the shares are trading lower than what they were trading at when the original owner purchased them, the cost basis becomes the fair market value at the time the gift was made.
Calculating Cost Basis of Real Estate
The cost basis of real estate is usually the property price plus any capital expenditures accrued during renovation.
Calculating Cost Basis For a Stock Split
In a stock split, the cost basis per share will change based on the new shares issued but the cost basis of the whole lot won't. This is because the market value of the investment doesn't change, just the number of shares.
Bottom Line
Cost basis is essentially the purchase price of an asset plus any additional purchasing costs. Tracking basis is important for tax purposes and performance reporting. Cost basis is calculated using one of three commonly used methods, depending on your situation. Calculation of cost basis can change depending on the type of asset sold.
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