Cost Basis

What Is Cost Basis?

Cost basis is the original value of an asset for tax purposes, normally the purchase price, adjusted for stock splits, dividends, and return of capital distributions. This value is utilized to determine the capital gain, which is equivalent to the difference between the asset's cost basis and the current market value. The term can likewise be utilized to depict the difference between the cash price and the futures price of a given commodity.

Figuring out Cost Basis

At the most essential level the cost basis of an investment is the total amount originally invested, plus any commissions or charges associated with the purchase. This can either be depicted in terms of the dollar amount of the investment, or the effective per share price paid for the investment.

Utilizing the right cost basis, additionally alluded to as the tax basis, is important particularly if you reinvested dividends and capital gains distributions rather than taking the earnings in cash. Reinvesting distributions increases the tax basis of your investment, which you must account for to report a lower capital gain and consequently pay less tax. On the off chance that you don't utilize the higher tax basis, you could wind up paying taxes two times on the reinvested distributions. Determining the right cost basis is likewise the first step while computing gains and losses after a stock is sold.

Reinvesting dividends increase the cost basis of a stock since dividends are utilized to buy more shares.

The average cost basis method is usually utilized by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where your assets are held. Numerous brokerage firms default to the average cost basis method. Investors can likewise look over different methods including: first in first out (FIFO), last in first out (LIFO), high cost, low cost from there, the sky is the limit. When a cost basis method is determined for a specific mutual fund it must stay in effect. Brokerage firms will give investors suitable annual tax documentation on mutual fund sales in light of their cost basis method races. The concept of cost basis is fundamentally direct, yet it can become muddled in numerous ways. Tracking cost basis is required for tax purposes yet in addition is expected to help track and determine investment achievement. The key is to keep great records and improve on the investment strategy where conceivable.

Illustration of Cost Basis

For instance, in the event that 100 shares of a stock were purchased for $1,000 last year, with the first year of dividends amounting to $100 and second year dividends amounting to $200, which was all reinvested, applicable tax law believes these reinvested earnings to be income. For tax calculation purposes, the adjusted cost basis when the stock is sold will be recorded at $1,300 rather than the original purchase price of $1,000. In this way, assuming that the sale price is $1,500, the taxable gain would just be $200 ($1,500 - $1,300) rather than $500 ($1,500 - $1,000). In the event that the cost basis is erroneously recorded as $1,000, this outcomes in a higher tax liability than would ordinarily be due.

Cost Basis Comparisons

Cost basis comparison can be an important consideration. Expect that an investor made the following back to back fund purchases in a taxable account: 1,500 shares at $20, 1,000 shares at $10 and 1,250 shares at $8. The investor's average cost basis is calculated by partitioning $50,000/3,750 shares. The average cost is $13.33.

Assume the investor then, at that point, sells 1,000 shares of the fund at $19. The investor would have a capital gain of $5,670 utilizing the average cost basis method.

• Gain/loss utilizing average cost basis: ($19 - $13.33) x 1,000 shares = $5,670

Results can fluctuate altogether by cost basis.

• First in first out: ($19 - $20) x 1,000 shares = - $1,000
• Last in first out: ($19 - $8) x 1,000 = $11,000
• High cost: ($19 - $20) x 1,000 shares = - $1,000
• Low cost: ($19 - $8) x 1,000 = $11,000

In this case, the investor would be better off assuming they had chosen the FIFO method or the high cost method to determine the cost basis prior to selling the shares. These methods would bring about no tax on a loss of $1,000. With the average cost basis method, the investor must pay a capital gains tax on the gain of $5,670.

What Stock Splits Mean for Cost Basis

Assuming the company splits its shares, this will influence your cost basis per share, however not the real value of the original investment or the current investment. Continuing with the above model, assume the company issues a 2:1 stock split where one old share gets both of you new shares. You can ascertain your cost basis per share in two ways:

• Take the original investment amount ($10,000) and partition it by the new number of shares you hold (2,000 shares) to show up at the new per share cost basis ($10,000/2,000=$5.00).
• Take your previous cost basis per share ($10) and partition it by the split factor of 2:1 ($10.00/2 =$5.00).

Cost Basis of Gifted or Inherited Shares

In the event the shares were given to you as a gift, your cost basis is the cost basis of the original holder who gave you the gift. On the off chance that the shares are trading at a lower price than when the shares were gifted, the lower rate is the cost basis. On the off chance that the shares were given to you as inheritance, the cost basis of the shares for you as the inheritor is the current market price of the shares on the date of the original proprietor's death.

There are many factors that will influence your cost basis and eventually your taxes when you choose to sell. On the off chance that your true cost basis is indistinct, if it's not too much trouble, counsel a financial advisor, accountant or tax lawyer.

Cost Basis and Futures Contracts

With respect to futures, the cost basis is the difference between a commodity's nearby spot price and its associated futures price. For instance, in the event that specific corn futures contract is trading at $3.50, while the current market price of the commodity today is $3.10, there is a 40-penny cost basis. In the event that the reverse were true, with the future contract trading at $3.10 and the spot price being $3.50, the cost basis would be negative 40 pennies, as a cost basis can be positive or negative contingent upon the prices in question.

The neighborhood spot price addresses the common price for the underlying asset, while the price listed in a futures contract alludes to a rate that would be given at a predetermined point from here on out. Futures prices differ from one contract to another relying upon the month when they are set to lapse.

Similarly as with other investment mechanism, the spot price changes relying upon current neighborhood market conditions. As the delivery date draws near, the price of futures and the spot price shift nearer together.

Highlights

• Cost basis is the original price that an asset was acquired, for tax purposes.
• Capital gains are registered by working out the difference from the sale price to the cost basis.
• Several accounting methods exist to change the cost basis so it is better, yet be careful to follow IRS rules.