Definition and Examples of Cost Basis
Your cost basis—sometimes referred to as just “basis”—is the amount you paid for an investment. When you sell that investment, you need to report your cost basis to the IRS, provided the investment was in a taxable account. Your capital gain or loss is the sale price minus your cost basis. If you have capital gains, you may owe taxes on that money.
When you invest in stocks or bonds, your cost basis often will be the price you paid for the asset. However, it’s not always that simple. You’ll need to calculate your adjusted cost basis, which may be higher or lower than what you paid, if certain events occurred.
Paying investment fees and commissions, although increasingly rare, would increase your adjusted cost basis. If you earned dividends or capital gains and you reinvested them, your cost basis also would increase by the amount you reinvested.
For example, suppose you owned $1,000 of stock ABC and it paid a 2% dividend, which would amount to $20. If you reinvested the dividends, your adjusted cost basis would be $1,020. If you sold your shares for $1,500, your capital gain would be $480, based on the adjusted cost basis of $1,020, not your initial investment of $1,000.
When you earn bond interest, it’s taxed as ordinary income and not as a capital gain.
With real estate, cost basis is also used to calculate capital gains and losses. However, your adjusted basis can vary significantly from the price you actually paid for the property. If you made improvements to the property or paid to fix damages, your basis would increase. Depreciation, insurance payouts, and certain deductions can decrease your basis.
When you inherit stocks or any other property, your basis isn’t what the owner paid for it. Instead, you’ll generally use the fair market value on the date of the individual’s death as your cost basis. This is known as a step up in basis.
The rules are more complex when someone who is still living gifts you stock. For a detailed breakdown, check out IRS Form 550. Essentially, it boils down to the following:
- Stock’s fair market value (FMV) is equal to or greater than the donor’s basis: Your basis is the donor’s basis.
- Stock’s FMV is less than the donor’s basis: Your basis is the fair market value on the date of the gift.
How Cost Basis Works
The purpose of cost basis isn’t to measure your investment returns. Cost basis is used to determine what you owe for taxes.
If you sell stocks, bonds, mutual funds, or exchange-traded funds (ETFs), in a taxable account, your brokerage firm will send you IRS Form 1099-B. You’ll use that information to report your cost basis to the IRS on Form 8949 and on Form 1040, Schedule D.
Calculating cost basis can be challenging when you own a stock or mutual fund and you’ve made multiple buys at different prices. Here are the methods you can use:
- First-in, first-out (FIFO) method: The first shares you purchased are treated as the first shares you sell. This is the default method of the IRS and the method most brokerages automatically use.
- Average cost method: You divide the total cost of all shares by the number of shares you hold, then use the average as your cost basis. This is only an option for mutual funds and certain dividend reinvestment plans (DRIPs). You can’t use the average cost method to calculate the basis for individual stocks.
- Specific share identification method: You identify to your broker the specific shares you’re selling. You’ll need to tell your broker at the time of the sale that you’re using this method, so keep good records to document your basis.
How to Calculate Cost Basis
To show how each method works, let’s look at an example. Say you own 400 shares of Company XYZ’s stock. You purchased your shares over the course of four years:
- January 2018: 100 shares at $10 per share, for $1,000 total
- January 2019: 100 shares at $12 per share, for $1,200 total
- January 2020: 100 shares at $15 per share, for $1,500 total
- January 2021: 100 shares at $16 per share, for $1,600 total
Your total investment amount is $5,300.
In May 2021, you decided to sell 150 of your shares. Here’s how each method would work.
First-In, First-Out (FIFO)
You sell all 100 of the shares you bought for $10 ($1,000), plus 50 of the shares you bought for $12 ($600). Your cost basis is $1,600.
You take your total cost to purchase all of your shares, which is $5,300, and divide by 400. This brings your cost basis to $13.25 per share. Multiply that by the number of shares you’re selling, which is 150. Your cost basis is $1,987.50.
You choose which shares you want to sell. You could sell all 100 of the shares you bought for $16 ($1,600), plus 50 of the shares you bought for $15 ($750). That would make your cost basis $2,350. However, because you held the $16 shares for less than one year, you’ll be taxed at short-term capital gains tax rates.
You could keep the $16 shares and sell all 100 of your $15 shares ($1,500), plus 50 of the shares you bought for $12 ($600). Your cost basis would be $2,100. Generally speaking, you’ll want a higher basis since it will reduce your capital gains, but this option could pay off if you’re taxed at long-term capital gains rates.
If you have capital losses, you can only use them to lower your taxable income by $3,000. However, if your losses exceed that amount, you can carry them forward to future years.
What It Means for Individual Investors
You only need to report your cost basis for investments you sell in taxable accounts. Cost basis doesn’t matter for tax-advantaged accounts, such as 401(k) plans, individual retirement accounts (IRAs), or 529 plans, because the growth in these accounts happens tax-free. Depending on the type of account, the money may be taxed as ordinary income when you withdraw it, but you won’t pay capital gains taxes on your investments.
Generally, the lower your cost basis, the higher your potential capital gains. But, cost basis isn’t the only consideration when you’re trying to minimize capital gains taxes.
As in the example above, selling securities you’ve held for one year or more typically comes with a lower tax rate. When you sell an investment you’ve held for less than one year, it’s treated as a short-term capital gain, and it’s taxed as ordinary income. If you’re an active trader, holding onto investments for at least one year may yield big tax savings. Long-term capital gains tax brackets are 0% or 15% for most investors, with the highest earners paying no more than 20% (although there are few other exceptions when the tax rate could be up to 28%).
- Cost basis is the amount you paid for an investment, but it isn’t always what you paid when you purchased it.
- Reinvesting dividends or capital gains will increase your cost basis.
- If you sell assets, use the information your brokerage provides you on Form 1099-B to report your cost basis when you prepare your tax return.
- The lower your cost basis, the higher your potential capital gains taxes.
- Cost basis isn’t a factor for tax-advantaged accounts, such as 401(k)s, IRAs, or 529 plans.
Frequently Asked Questions (FAQs)
How do you determine the cost basis of an inherited house?
Typically, the cost basis of an inherited house is its fair market value on the date of the owner’s death. You can also use the fair market value on an alternate valuation date, but only if the executor of the estate files an estate tax return and chooses to use the alternate valuation on the return.
What is cost basis per share?
Cost basis per share is the amount you paid for each share after accounting for factors such as dividend reinvestment, investment fees, and stock splits. The default method for calculating cost basis per share is the first-in, first-out (FIFO) method. For mutual funds and some dividend reinvestment plans, you can use the average cost method.
What does ‘cost basis not reported to the IRS’ mean?
The Emergency Economic Stabilization Act of 2008 required brokers and mutual fund companies to report cost basis to the IRS. This was phased in between 2011 and 2014 for most securities. Assets acquired after 2014 are “covered” and the company will report the cost basis to the IRS. Those acquired before 2011 are “noncovered” and may be listed as “not reported to the IRS.” In this case, you need to report the basis to the IRS when you file taxes.