What is Cost Basis?
Cost basis refers to the original price of an asset. Cost basis is sometimes called tax basis.
How Does Cost Basis Work?
Let's assume you purchase 100 shares of XYZ Company stock for $5 per share, and you pay a $10 commission for the purchase. Your cost basis would be:
(100 x $5) + $10 = $510
Income realized from the asset, including dividends and capital distributions (even if they are reinvested rather than received in cash) increases the cost basis. Thus in the above example, if your stock paid a $1-per-share dividend every year for three years, your basis would increase to:
$510 + (100 x $1 x 3) = $810
money spent on improvements to an asset (such as certain home improvements) are added to the asset's cost basis, and depreciation on the asset is subtracted from the cost basis.
Why Does Cost Basis Matter?
An asset's cost basis becomes very important when the owner sells the asset. The difference between the sale price and the cost basis is called a capital gain (if the sale price is higher than the cost basis) or a capital loss (if the sale price is lower than the cost basis). Capital gains are generally only taxable when the investor actually sells the asset. Realized losses can often offset these gains and thus lower the investor's potential capital-gains taxes. The length of time the asset is held, among other things, determines the tax effect of the gain or loss. Changes in tax rates may also influence an investor's concern about cost basis.
An asset's cost basis is usually based on its original purchase price, but sometimes people inherit assets rather than purchase them. In these cases, the cost basis of the asset becomes the value of the asset at the time the investor inherits it (this is called a step-up in the basis).
Often, investors accumulate shares of the same stock at different prices over time. Because of this, when the investor sells some of the shares, he or she must identify which shares from the inventory were sold in order to calculate capital gains or losses. In general, investors want to minimize taxable gains by selling the shares with the highest cost basis first. However, if the investor cannot identify which shares are which, the IRS requires use of the first-in-first-out (FIFO) method, meaning that the investor must assume he or she first sells the shares that are held the longest. These older shares may not have the highest cost basis of the investor's inventory of shares, and thus the method could inflate the investor's tax bill.