Cost basis is the initial value of an asset, usually, the purchase price. It is a useful measure for evaluating investment performance. Additionally, it is always relevant for computing the capital gain/loss and resulting tax position associated with the disposal of an asset.
What Is Cost Basis?
Cost basis is the initial value— typically the amount paid at the time of purchase — of an asset that has been adjusted to reflect certain transactions occurring prior to disposal. The determination of cost basis varies by asset type.
For an equity security — commonly known as a stock, cost basis is generally the purchase price of the stock plus any additional acquisition costs, such as brokerage fees and commissions, plus any reinvested dividend distributions minus any return of capital distributions.
Cost Basis for Equities = Purchase Price + Acquisition Costs + Reinvested Dividends – Capital Distributions
The determination of cost basis is more complicated for a fixed income security, such as a bond. Here, if the purchase price is above or below the amount due at maturity of the debt (known as the par value), the difference is paid down gradually over time (or amortized to par) until maturity. Essentially, this results in a continual, gradual change in the cost basis.
Cost Basis for Fixed Income = Purchase Price + Acquisition Costs + Amortization Adjustment
For a fixed asset, such as a piece of manufacturing equipment, the cost basis is generally the price paid for the asset plus any costs necessary to put it into service, such as delivery fees and installation charges, less accumulated depreciation.
Cost Basis for Fixed Assets = Purchase Price + Implementation Costs – Accumulated Depreciation
Why Is Cost Basis Important?
Cost basis is useful for evaluating investment performance, particularly when assessing the holding period return (HPR) of a financial security. Fundamentally, this cash-oriented measure is computed as follows:
HPR = (Inception-to-date Net Income Received + Disposal Price – Acquisition Price) / Acquisition Price
With an appreciation for the asset-specific nuances noted above, we can modify the formula as illustrated below.
Adjusted HPR = (Inception-to-date Net Income Recognized + Disposal Price – Cost Basis) / Cost Basis
This adjusted formula goes beyond the traditional, cash-focused HPR measure to incorporate pertinent non-cash accounting transactions. Some finance purists may frown on this approach, but it has practical application in many real-world scenarios. Regardless, both formulas are directionally consistent.
Beyond its usefulness as a performance measurement, cost basis is always relevant for computing the capital gain (or loss) and resulting tax liability (or credit) associated with an asset disposal. For this reason, cost basis is often referred to as tax basis.
The difference between the disposal price and the cost basis of an asset is referred to as a realized capital gain (if positive) or a realized capital loss (if negative). Furthermore, capital gains are taxable, while capital losses can reduce tax liabilities.
Assets held longer than a year are usually subject to a long-term capital gains tax, while assets held less than a year are subject to a short-term capital gains tax. The long-term rate is typically lower than the short-term rate, which makes the timing of an asset disposal quite an important consideration.
IRS Reporting Requirements
In the U.S., taxpayers have a responsibility to report any gains and losses realized on asset disposals to the Internal Revenue Service (IRS) via their annual income tax filings. With each filing, you are required to report cost basis information on any disposals.
In some situations, this may be easy to do; but, in others, it can become very difficult. For example, imagine a stock position you bought over a 10-year period via many purchases. The resulting data set is huge with a wide range of purchase prices. Now, you’ve started to sell some of the stock, and you need to report gain/loss and cost basis information to the IRS. Without a sound recordkeeping system, handling all of this is likely to be overwhelming.
Fortunately, in these situations, you can usually rely on your brokerage firm to supply the information, as it is required to report all of this to the IRS via Form 1099-B. That’s not to suggest you should be unconcerned with the process. From an inventory draw-down perspective, you dictate how the brokerage firm is supposed to handle disposals, and you (perhaps, with the assistance of a financial planner) should maintain a strategic awareness of this directive. Doing so can significantly improve your tax position.
Learn more about the details of permissible disposal methods prescribed by the IRS at How To Figure Gain or Loss.
Cost Basis Illustration
Now that we have a general understanding of cost basis, let’s take a look at how it is calculated for a common stock.
Assume you buy 100 shares of ABC Corporation for $10 per share, and your brokerage firm charges you a $6 commission. Your cost basis is as follows:
$100 X $10 + $6 = $1,006
Then, over the course of the year, you receive a $2 cash dividend per share, which you automatically reinvest. Your basis will grow as follows:
$1,006 + 100 X $2 = $1,206
Finally, in the beginning of the following year, you buy another 100 shares at $12 per share, and your brokerage firm charges you a $6 commission. Following the purchase, your total cost basis is as follows:
$1,206 + 100 X $12 + $6 = $2,412
Inheritances and Gifts
As noted above, an asset’s cost basis usually reflects its purchase price; however, in many instances, ownership stems from an inheritance, not a purchase. In these cases, cost basis is the market value of the asset at the time of inheritance.
This is commonly referred to as the “stepped-up” basis, which implies an expectation for a price increase over time. In the case of a price decline, “stepped-down” is a more fitting term.
In the event of a gift, the cost basis is the lower of the current market value of the asset or the giver’s cost basis.
Another unique transaction that can impact cost basis determination is a like-kind exchange, such as a 1031 exchange (for real investment property) and a 1035 exchange (for life insurance policies and annuity contracts). These numeric references relate to provisions of the IRS code that allow for the tax-free transfer of one asset for a largely similar asset.
Essentially, this entails the transfer of the cost basis from the original asset to the new one. While conceptually straightforward, these transactions can be fairly complex, with a number of unique requirements. Be sure to consult with a tax expert before pursuing one.
Taxable vs. Tax-Advantaged Brokerage Accounts
When thinking about a security’s cost basis and the potential gain or loss associated with its disposal, take care to differentiate between taxable and tax-advantaged brokerage accounts. While the gain on the sale of a security is generally taxable in the year of disposal, this only pertains to securities held in taxable accounts.
Traditional, tax-advantaged accounts, such as IRAs and 401(k) plans, defer taxation until withdrawals are made, and Roth-style accounts are exempt from taxation. These features offer significant growth potential to savers, while making the tax drag associated with a security sale irrelevant.
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