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.
SoFi Invest
The
information provided is not meant to provide investment or financial advice.
Investment decisions should be based on an individual’s specific financial
needs, goals and risk profile. SoFi can’t guarantee future financial
performance. Advisory services offered through SoFi Wealth, LLC. SoFi
Securities, LLC, member FINRA / SIPC .
The umbrella term “SoFi Invest” refers to the three investment and trading platforms
operated by Social Finance, Inc. and its affiliates (described below).
Individual customer accounts may be subject to the terms applicable to one or
more of the platforms below.
Tax Information: This
article provides general background information only and is not intended to
serve as legal or tax advice or as a substitute for legal counsel. You should
consult your own attorney and/or tax advisor if you have a question requiring
legal or tax advice.
Third Party Brand Mentions: No
brands or products mentioned are affiliated with SoFi, nor do they endorse or
sponsor this article. Third party trademarks referenced herein are property of
their respective owners.
Automated Investing
The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered
Investment Advisor (“SoFi Wealth“). Brokerage services are provided to SoFi
Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer
and member FINRA / SIPC ,
(“SoFi Securities”).
Active Investing
The Active Investing platform is owned by SoFi Securities LLC. Clearing and
custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described
above, please visit http://www.sofi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the
Registered Representatives of SoFi Securities are compensated for the sale of
any product or service sold through any SoFi Invest platform. Information
related to lending products contained herein should not be construed as an
offer to sell, solicitation to buy or a pre-qualification of any loan product offered
by SoFi Lending Corp and/or its affiliates.
Financial Tips &
Strategies: The tips provided on this website are of a
general nature and do not take into account your specific objectives, financial
situation, and needs. You should always consider their appropriateness given
your own circumstances.
Crypto: Bitcoin
and other cryptocurrencies aren’t endorsed or guaranteed by any government, are
volatile, and involve a high degree of risk. Consumer protection and securities
laws don’t regulate cryptocurrencies to the same degree as traditional
brokerage and investment products. Research and knowledge are essential
prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB . PDF File, have
issued public advisories concerning digital asset risk. Cryptocurrency
purchases should not be made with funds drawn from financial products including
student loans, personal loans, mortgage refinancing, savings, retirement funds
or traditional investments.
Investment Risk: Diversification
can help reduce some investment risk. It cannot guarantee profit, or fully
protect in a down market.
External Websites: The
information and analysis provided through hyperlinks to third party websites,
while believed to be accurate, cannot be guaranteed by SoFi. Links are provided
for informational purposes and should not be viewed as an endorsement.
Fund Fees
If you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by
buying them yourself or via investing in SoFi Invest’s automated investments,
formerly SoFi Wealth), these funds will have their own management fees. These
fees are not paid directly by you, but rather by the fund itself. these fees do
reduce the fund’s returns.. Check out each fund’s prospectus for details. SoFi
Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs
for investing such funds on behalf of advisory clients, though if SoFi Invest
creates its own funds, it could earn management fees there.
Image Credit: ipopba/ iStock.
