Understanding the cost basis of an investment
What is cost basis?
It is important for investors to understand the cost basis of investments and how to calculate it for tax planning purposes. It is the total purchase price of an investment, including purchases that you completed with capital gains distributions or the reinvestment of dividends. This also includes other costs that you paid such as commissions and transaction fees. Specific identification method is one of the many cost basis accounting strategies used.
Calculating the adjusted cost basis for a mutual fund investment can help to determine the amount of taxes that you might pay for your shares. This applies as well for figuring out the gains or losses for when you want to buy shares or sell them.
To calculate the cost basis for a security using generally accepted accounting principles, you can divide the amount that you paid for an investment by the number of shares. Next, compare the average cost to the selling price of the shares to determine if you have realized gains or losses for tax reporting purposes.
Investors who have shares in mutual funds usually use the calculation for figuring out the taxes that they might owe. Following GAAP to calculate the cost basis allows them to report their gains or losses accurately on their tax returns.
Specific identification method
The specific identification method is used when investors sell assets within a specific class that they hold in taxable investment accounts. It is an accounting strategy that helps the investors to improve their tax treatment when they sell shares that were purchased at different prices and at different times.
The specific identification method allows investors to choose which of their shares are sold. For example, the investors might choose to count the shares that they purchased at the highest price as the ones that they sell so that they can minimize the capital gains that they have to report.
Statistics on capital gains and losses
According to the Department of the Treasury, slightly more than 11 million tax returns included net capital gains in their reported adjusted gross incomes. This included the following types of capital gains that people reported:
- Gains from assets sold that were held for investment
- Gains from selling certain types of business property
- Net gains from involuntary conversions of property through theft or casualty
- Gains received from S-corporations or partnerships
Tax basis methods
The cost or tax basis of an asset is the original price that you paid when you purchased it. It includes the total cost such as the price of a security as well as any transaction fees or commissions that you were charged. There are multiple methods of figuring out the tax basis of an asset that you want to sell that follow GAAP standards.
It is important that you understand the various methods so that you can choose the one that allows the most tax optimization by offsetting other gains that you must report. Minimizing the taxes that you might have to pay may help you to increase your net worth.
The specific identification method of calculating the tax basis for shares is when you choose which shares of the same company or mutual fund that are purchased at different times and prices to sell. With this method, you choose the shares that will minimize your taxable gains or offset other gains.
If you are able to identify the shares that you sold by the date that you purchased them and the amount that you paid, you can use your tax basis for those specific shares rather than the tax basis for others. To use the specific identification method, you should keep records of all of the purchases that you have made. You then tell your brokerage which shares that you want to sell.
In most cases, the shares that you purchased that have the highest cost basis will be the best ones to sell. You can figure out the tax basis of shares that you have purchased by using a simple formula. For example, if you purchased five shares of a security on a specific date at a cost of $20 per share and were charged a $6 commission, you can calculate the basis as follows:
(5 x $20) + 6 = $106
If you later purchased five more shares at a price of $30 and a commission of $6, your basis for those shares would be as follows:
(5 x 30) + 6 = $156
If you then choose to sell five shares at a price of $45 per share, you can offset your gains by choosing the five shares that had a higher tax basis.
Some investors use the average cost method to calculate their tax basis. In this method, you add up the cost of all of the shares and divide the result by the total number of shares. Using the example of the 10 shares from above, the formula would work as follows:
(5 x $20) + 6 + (5 x $30) + 6 = $262/10 = an average cost per share of $26.20
Next, multiply the average cost per share by the number of shares that you sold. If you sold five shares, you would do this as follows:
5 x $26.20 = $131
When you compare this method to the specific identification method as described above, you can see that the average cost per share method may not always be the most effective for tax optimization purposes. However, this is the method that is commonly used by brokerage firms and by investors for mutual fund tax reporting.
The first in first out method or FIFO is a method that you can use if you are unable to determine the specific shares that you are selling. With the first in first out method, you count the shares that you sold as the ones that you purchased at the earliest time.
In this method, you use the cost of the oldest shares to calculate your tax basis. For investors who tend to buy and hold their shares, the oldest shares are often the least costly, which can result in higher taxes because of the lower tax basis of the shares. For partial sales, the IRS assumes that you are selling your oldest shares first. This can lead to a higher gain because of the greater appreciation in the value of the oldest shares.
The last in, first out or LIFO method counts the most recently acquired investments like the ones that are sold first. This method is only allowed to be used in the U.S. The International Financial Reporting Standards do not allow the use of the LIFO method.
The LIFO method creates higher costs and lowers your net income when prices are rising, which helps to lower your taxable income. It creates lower costs and increases your net income during times when prices are falling, which increases your taxable income.
Under the high-cost method of calculating the tax basis, you sell the shares that have the highest price per share first. When this method is chosen, you choose the highest-priced shares regardless of the date that you purchased them.
Under the low-cost method of calculating the tax basis of shares, you count the shares that were purchased at the lowest price per share as the ones that are sold first. This is done regardless of the purchase dates of the shares.
Investors who use the specific lot identification choose specific shares to sell by the lot to determine the tax basis. Under this method, you might choose all of the shares that you purchased on a specific date from the company and count those as the ones to sell.
The tax basis of stocks, futures, and other types of securities for tax purposes is the original value of the asset, which is typically the purchase price. It is then adjusted for dividends, stock splits, and returns of capital distributions to arrive at the adjusted cost basis.
Adjusted cost basis
The tax basis of an asset is important for figuring out your gains or losses. The IRS also allows investors to adjust the tax basis up or down for a number of different reasons, which can result in a reduction of the taxes that you will have to pay. Here are a few things that may result in an adjusted cost basis.
If you have shares that pay dividends and reinvest them, the reinvested dividends will increase your cost basis and reduce any eventual gain that you realize from selling the shares. If you purchase shares of mutual funds or shares of stock through a dividend reinvestment plan, you may be able to choose the average cost method.
When mergers occur, a company will issue cash, stock, or a combination. Any payouts that you receive in cash will be realized as a gain and will be taxable. The gains or losses of the issued shares will be unrealized. However, they will be recorded as the new cost. The companies must give guidance on the percentages and the breakdowns.
When an old company divides and creates a new one, some of the tax cost will go with the new company. The investor will be given the percentage by the company.
When companies file for bankruptcy, the adjusted cost basis will depend on the chapter under which the bankruptcy cases were filed. If a company files for Chapter 7 liquidation bankruptcy, the shares are worthless because the company will no longer exist. This would be considered a capital loss on your taxes.
If a company files for a reorganization under Chapter 11, however, the shares may still be traded and may retain some value. When this happens, the initial cost basis calculations will apply.
Chapter 11 emergence plans are when common stock is given in exchange for some of the bonds that were held before the companies declared bankruptcy. The fair market value of the stock on the effective date will be the same as its tax basis.
Stock splits may also be accounted for in an adjusted cost basis. Splits affect the tax basis per share but not the value of the current or of the original investment. To calculate the new tax basis per share, take the original investment amount and divide it by the new number of shares that you hold. Alternatively, you can take your previous per-share tax basis and divide it by the split factor.
When you calculate the adjusted cost basis, factor commissions into the tax basis. For company distributions, the fund’s share price falls by the total of the per-share distribution to the shareholders of the fund.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 was a federal law that was passed to help to bail out the big banks in the U.S. It requires mutual fund companies and brokerage firms to report on their consolidated Form 1099s their customers’ tax basis and holding periods on covered securities at the time the securities are sold.
This requirement helps the accuracy of the reporting of gains and losses. It simplifies year-end tax preparation for covered securities and non-covered securities.
Covered securities are securities that are subject to the tax basis reporting rules. These are shares that were acquired on or after Jan. 1, 2012. These include the following securities:
- Equities purchased after Jan 1, 2011
- Equities purchased under an enrolled dividend reinvestment program or DRIP after 2012
- Mutual funds purchased after Jan. 1, 2012
- Equity options
- Non-1256 index options
- Stock warrants
- Basic debt instruments purchased after Jan. 1, 2014
- More complex debt instruments such as convertible debt, variable and stepped interest rates, STRIPS and TIPS that were acquired after Jan. 1, 2016
For non-covered securities, the tax basis is not required. These include shares that were acquired before Jan. 1, 2012, or shares that were purchased on or after the effective date when the tax basis is unavailable.
The best cost basis for you
As you can see, choosing the best tax basis method is important when you sell your shares. For fund sales, use the average cost method. For the sale of individual shares, the easiest method is the FIFO method.
If you are tax savvy, using the specific identification method may help you to save tax money. This is especially true if you combine it with other tax-planning strategies.
Tips for cost basis recording
Following these tips for tax basis recording can help you to save money on your taxes and will make tax preparation easier. Record the stock dividends or non-dividend distributions when you receive them. For inherited securities, find the fair market value of the securities on the date that you received them. If you cannot find it, you may need to use the previous owner’s adjusted basis.
If you jointly own stock with your spouse, and he or she dies and leaves you the shares, you may be able to step up the basis on half of the shares to the price at the time that your spouse passed away. For gifted securities, you will need to obtain the cost basis of the stock from the person who gifted the shares to you. If you sell and realize a gain, you will use the giver’s basis. If you sell the shares and realize a loss, the basis will either be the giver’s basis or the value of the stock when it was given to you, whichever is lower.
Cost basis tax reporting
As a taxpayer, you are responsible for reporting to the IRS any security that you bought and sold as part of the cost-basis information. To do this, fill out Form 8949. IRS Publication 550 offers guidance on how to calculate the cost basis under different circumstances. It is a good idea to get help from a tax professional when you are computing and reporting a loss or a gain.
Because of a law passed by Congress in 2008, brokerage firms, mutual funds, and others must provide copies of any 1099-B forms to investors by Feb. 15 of each year. Check that the amount of your basis matches the broker’s report. If it differs, contact your broker immediately.
There are some exclusions from the cost basis reporting requirements, including the following:
- Compensatory options
- Broad-based index options that are treated like regulated futures contracts
- Short-term debt securities with a term of one year or less
- Debt that is subject to an accelerated repayment of principal
- Unit Investment Trusts
Cost basis summary
When you sell shares, you must be able to identify which shares were sold in order to calculate your gains or losses. Your goal is to minimize the taxable gains by selling the shares that have the highest cost basis first so that you can increase your net worth.
M1 Finance uses built-in tax efficiency to help investors to reduce the amount that they might owe on taxes automatically. However, you will still need to file a few additional forms with the rest of your return when you sell shares. It is best to enlist the help of a tax professional when tax planning.
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Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.