What is cost basis?

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It’s common for people to avoid thinking about taxes until filing season is upon them. Unfortunately, this can lead to missed opportunities to reduce tax payments. Planning ahead and understanding tax rules is useful for investors to optimize their finances year-round.

Related: A guide to tax-efficient investing

Cost Basis Defined

Cost basis, also referred to as tax basis, is the value of an asset that is used for tax purposes when calculating gains or losses after a sale. This is generally the price that the asset was purchased at, adjusted for any dividends, mergers, stock splits, and return of capital distributions.

When an asset is sold, capital gains are the amount that the asset rose in value since it was purchased. Capital losses are the amount that an asset decreased in value between purchase and sale. Investors pay taxes on capital gains and can sometimes offset the amount they pay in capital gains tax with capital losses.

Cost basis also is adjusted for any broker fees, commissions, wash sales and corporate action events that affect the purchase. It is either calculated as the price per share or unit of the investment, or as the total amount paid for a particular asset trade.

If someone inherits an asset rather than buying it, this is called a step-up, and the cost basis is calculated as the value of the investment at the time it was inherited. If an investor is gifted shares, the cost basis stays the same as it was when the original investor bought them.

If the shares have decreased in value from the purchasing price at the time they are gifted, the cost basis is the new, lower price.

Note that the information in this article isn’t meant as investment or tax advice. It is meant to educate investors about tools and terminology used for trading and taxation purposes. For financial advice and personal portfolio questions, reach out to a tax advisor.

Why Is Cost Basis Important?

It’s important for investors to understand how cost basis works when planning for and filing taxes. When traders know how much they paid for assets, they can calculate how much they will pay in capital gains taxes when they sell those assets, and decide when to sell each asset. Cost basis must be reported to the IRS when filing taxes.

There are different strategies for timing the sale of assets to time capital gains tax payments.

Cost basis can be complicated to calculate if a trader bought and sold shares on different dates, at different prices. If, for example, investors are following the dollar-cost averaging investment method, calculating their cost basis can be complex.

If traders reinvest money they earn from capital gains distributions and dividends, this changes the cost basis of their assets, and in turn changes the amount of capital gains taxes they will owe. In order to lower capital gains taxes, investors must report these reinvestments. Otherwise, they pay taxes based on the original price, which may be significantly lower than later reinvestment prices.

There are different strategies for timing the sale of assets to time capital gains tax payments.

Factors That Affect Cost Basis

As mentioned above, several factors can affect cost basis. These include changes to company structures, such as stock splits and mergers, and personal investment decisions such as wash sales.

Wash Sales

A wash sale happens when an investor sells an asset at a loss, then purchases a similar asset within 61 days of the sale (30 days before or after the sale). The loss is not included in that year’s tax report. The loss gets added to the cost basis of the asset.

Stock Splits

Sometimes companies split their shares, which means if an investor originally held one share, after the split they own two. Stock splits affect cost basis but not the original or current value of the investment. If an investor bought one share for $10, and then the stock split so they held two shares. The cost basis would be $5 for each share.

Mergers

If a company is acquired by another company, the acquiring company issues stock or cash to shareholders. This will either need to be reported as income in the case of cash, or it will change the cost basis in the case of shares. Information is provided to investors from the company to help them calculate the new cost basis.

Bankruptcies

If a company declares bankruptcy, the shares may still be available for trade, and retain their original cost basis. However, there are some situations in which the cost basis gets more complicated, and if the company files for Chapter 7 bankruptcy and ceases to exist, the shares become worthless.

How Do You Calculate Cost Basis?

How cost basis is calculated can make a significant difference in capital gains taxes. Different accounting methods are used to sell off shares and calculate the cost basis. Each has advantages and disadvantages.

Let’s assume a trader bought 100 shares of Company X stock for $10 per share and paid a $10 commission for the purchase. The cost basis would be (100 x $10) + $10 = $1,010

If that stock paid out a $1 dividend each year, this would change the cost basis. For example, if $1 was paid out each year for six years, the cost basis would be calculated as follows: $1010 + (100 x $1 x 6) = $1,610

First In, First Out Method (FIFO)

There is no guarantee that stocks will increase in value over time, so those held the longest may have actually decreased in value.

Using this accounting method, individuals or tax preparers assume that the first assets purchased were the first ones sold.

For example, if a trader purchased 100 shares of a stock each year for five years, they would have 500 shares. If they then sell 100 shares, the FIFO method assumes that the shares sold were the ones purchased in the first year. This would set the cost basis at the price paid that year.

Often, the stocks purchased first were bought at the lowest price, so when those are sold they have the largest capital gain. However, there is no guarantee that stocks will go up in value over time, so those that have been held the longest may in fact have decreased in value.

If someone can’t label which shares were sold, the IRS defaults to the FIFO method. That is another reason it’s important for investors to keep track of their purchases to ensure they have more control over their taxes.

One reason the FIFO method is beneficial is that if investors have held an asset for longer than one year, their capital gains tax rate is lower when they sell it.

Last In, First Out Method (LIFO)

The LIFO method calculates cost basis by saying that the most recent shares purchased are the ones that are being sold first. This method is not used internationally and is only allowed in the United States.

Specific Identification Method

Using the specific identification method, investors select which specific shares of stocks that they purchased go toward the cost basis calculation when they sell. They might select shares they’ve owned the longest, or shares they recently purchased.

To use this method, investors must keep track of each asset purchase they make and the price at which they buy assets. They then tell their brokerage which shares they want to sell.

Average Cost Method

Using this method, investors add up all the different prices they paid for assets, then divide by the number of shares to come with their cost basis. This may not be the most effective for optimizing taxes, but it is commonly used by both investors and brokerage firms, thanks to convenience.

High-Cost Method

With the high-cost method, the shares that were purchased at the highest price are sold first, regardless of the date of purchase. This method lets investors pay the lowest capital gains, because there is less difference between their purchase and sale price, and they may even have a loss from the investment.

Low-Cost Method

With the low-cost method, the shares purchased at the lowest price are sold first.

Learn more:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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