Key Takeaways
- Original purchase price plus fees determines cost basis.
- Adjusted for improvements, depreciation, and reinvested dividends.
- Cost basis used to calculate taxable capital gains or losses.
- Different methods (FIFO, average cost) affect gain calculation.
What is Cost Basis?
Cost basis is the original purchase price of an asset plus any associated fees like commissions or closing costs, adjusted over time for factors such as improvements, depreciation, or reinvested dividends. It determines your taxable capital gain or loss when you sell the asset, impacting how much you owe in taxes on the sale.
Understanding cost basis is essential for accurately calculating your tax liability under capital gains tax rules and managing your investments effectively.
Key Characteristics
Cost basis includes several components that affect the calculation of gains or losses:
- Purchase Price: The amount you originally paid for the asset.
- Acquisition Costs: Fees like brokerage commissions or closing costs added to your basis.
- Adjustments: Increases from capital improvements or reinvested dividends, and decreases from depreciation or casualty losses.
- Methods: Different methods such as FIFO or average cost can be used to calculate basis for stocks and mutual funds.
- Tax Reporting: Brokers often report cost basis to the IRS, but you must track it carefully for accuracy.
How It Works
When you sell an asset, your taxable gain or loss is the difference between the sale price and your adjusted cost basis. This figure is critical because it determines the amount subject to short-term or long-term capital gains tax rates.
For stock investments, brokers typically default to FIFO (first-in, first-out) accounting, but you can select other methods like specific identification or average cost, especially for mutual funds. Reinvested dividends, such as those from dividend stocks, increase your cost basis by adding the fair market value of newly purchased shares.
Examples and Use Cases
Here are practical examples to illustrate how cost basis applies:
- Stocks: Buying shares of Delta at different prices affects your cost basis calculation when selling partial holdings.
- Dividend Reinvestment: Reinvested dividends from dividend stocks add to your basis, reducing capital gains taxes on future sales.
- Broker Selection: Choosing a best online broker can simplify tracking and reporting of cost basis for your investments.
Important Considerations
Accurately tracking your cost basis is crucial to avoid overpaying taxes. Keep detailed records of purchase prices, fees, and adjustments such as reinvested dividends or depreciation. Be aware that the IRS requires proper reporting of cost basis on tax forms like 1099-B and Schedule D.
Complex situations like inherited assets or gifts may require professional advice to determine the correct basis. Regularly reviewing your cost basis helps you implement tax strategies such as loss harvesting or selecting the optimal accounting method to minimize your tax burden.
Final Words
Cost basis directly impacts your taxable gain or loss, so accurately tracking purchase price and adjustments is essential. Review your records and consult your broker or tax advisor to ensure your cost basis reflects all relevant factors before filing taxes.
Frequently Asked Questions
Cost basis is the original purchase price of an asset plus any associated fees, adjusted for improvements or depreciation. It is important because it determines your capital gains or losses when you sell the asset, which affects how much tax you owe.
The cost basis includes the purchase price plus fees like brokerage commissions or trading fees. It can also be adjusted over time for things like reinvested dividends or stock splits.
Capital improvements increase your cost basis, while depreciation or casualty losses decrease it. These adjustments help accurately reflect the asset's value for tax purposes when you sell.
Common methods include FIFO (first-in, first-out), average cost, and specific identification. Your broker usually defaults to FIFO but you can choose another method to potentially optimize your tax outcome.
For inherited assets, cost basis is usually the fair market value at the time of inheritance, known as a stepped-up basis. For gifted assets, the donor's original cost basis generally carries over to the recipient.
Yes, dividends that are reinvested to buy more shares add to your cost basis at their fair market value. This helps you avoid paying taxes twice on the same income.
For real estate, cost basis starts with the purchase price plus closing costs and can be adjusted for home improvements or depreciation if used for rental. This adjusted basis is used to calculate capital gains when you sell.
For restricted stock units (RSUs), the cost basis is the sum of the exercise price plus the ordinary income reported on your W-2 at vesting. This combined amount is used to determine your gain or loss upon sale.
