What is Cost Basis?

Cost basis is like a receipt from a store...

When you buy something from a store, you get a receipt of what you bought, how many units you purchased, and how much you paid. If you need to make a return, the store only refunds what you paid. Your cost basis is like a receipt for securities, tracking how much you paid for each share in your portfolio.

Cost basis is used to calculate capital gains taxes when you sell a security. Generally, the cost basis for a stock or other security is the amount that you paid to buy the share. Cost basis affects the tax implications of selling shares because it determines the capital gains or losses you book for the transaction.

If you sell something for more than its cost basis, you earn a capital gain and typically pay taxes based on the gain you earned. If you sell something for less than its cost basis, you’ve lost money on the investment. With certain restrictions, you can subtract the loss from your income when you file your tax return.

The cost basis for an investment can change in a few situations. For example, if you inherit a security from someone when he or she dies, its cost basis is usually the value of the security on the date of the person’s death.

When you buy a security like a stock or an ETF, each share you buy has a cost basis based on the price you paid. When you sell shares, you compare the price you sell the shares for with the price you paid to determine your gain or loss.

You can choose to sell shares in different ways. First-In, First-Out sells the shares you bought first. With specific identification, you choose individual shares to sell. Which shares you choose determines the cost basis of the shares you sell and therefore the capital gain or loss in the transaction.

With mutual funds and most ETFs, you can also choose to use the average cost of your shares when determining the cost basis of shares you sell. This method divides the total amount you paid for each share you own by the number of shares you own, regardless of the amount you paid for each individual share.

For example, if you bought one share in January for $10 and one share in March for $20, the average cost method produces a cost basis of $15 for each share.

This simplifies the calculation of cost basis but makes it harder to control the amount (and when) you pay in taxes by selling specific shares. It also forces you to use the average cost for all future sales until you sell every share you own in the mutual fund.

An investor has a strategy where they buy one share in the fictional company, Drill Bits Inc., every month. Over the course of the year, they buy five shares at $10, three shares at $15, two shares at $20, and two shares at $25.

Each share has an individual cost basis, but the total cost basis for the investor’s 12 shares is:

(5 * $10) + (3 * $15) + (2 * $20) + (2 * $25) = $185

Shares in company Drill Bits Inc. rise to $30, so the investor decides to start selling. If the investor sells all 12 shares, they will receive $360. Subtract out the $185 cost basis, and the sale produces a capital gain of $175.

The investor can also decide to sell only one share. If the investor wants to decrease their current capital gains, they can sell one of the shares bought at $25 to produce only a $5 gain. If they want to maximize capital gains, they can sell a share bought at $10 to produce a $20 gain.

Stock splits don't affect your overall cost basis for an investment, but they do change your per-share cost basis. To find the new cost basis per share after a stock split, you must divide your per-share cost basis based on the size of the stock split.

For example, if a company goes through a two-for-one split, a stockholder who owned 10 shares now owns twice as many. The stockholder should divide his or her per-share basis by two to find the new per-share basis.

If a company goes through a five-for-one split, divide the per-share basis by five to find the new basis.

For a reverse split (which combines multiple shares into one), stockholders should multiply the per-share basis based on the size of the reverse split. If the consolidation halves the number of shares, multiply the per-share basis by two. If it turns every four shares into one, multiply it by four.

To calculate the cost basis for individual shares that you own, you need to find the price that you paid for the share, then multiply it or divide it based on any stock splits or reverse splits that occurred.

There are multiple methods of calculating cost basis for individual transactions.

One is First-In, First-Out (FIFO). Using FIFO, you sell shares in the order you bought them. That means you use the cost basis of the first X shares you bought, where X is the number of shares you’re selling.

Last-In, First-Out (LIFO) is the opposite of FIFO, selling the more recently purchased shares first.

Another method is specific identification. Using this method, you choose individual shares to sell and use the costs basis of those shares.

For mutual funds, you can use average cost. Average cost is the total amount you paid to buy shares in the fund divided by the number of shares that you own.

Today, your brokerage must help with the cost basis reporting of shares you buy, but that wasn't always the case. If you own old stock you have to calculate the cost basis when you sell your investment.

One option is to assume the cost basis is $0. You’ll pay more tax than you truly owe, but you won’t get in trouble with the IRS for underpaying.

Another option is to reach out to the company’s investor relationships group. Often, investor relations can give you information on historical prices and stock splits or other cost basis information that you can use.

You can also do online research to track its history of stock splits and prices for the days that you made purchases. This requires more manual calculation, but is an option for people who want to do it themselves.

Each share you buy has a cost basis, so you can track the cost basis for every single share that you own. If you buy shares in the same fund or company at different times, you’ll likely pay a different price each time.

To find your total cost basis for your investment with multiple purchases, add the individual cost basis for each share you own.

For example, if you own three shares in Company XYZ, one bought at $10, one at $15, and one at $20, your total cost basis is $45.

Each cost basis method has pros and cons, and the best method depends on your investing goals. For example, some people say that using a method, like First-In, First-Out, keeps things simple.

First-In, First-Out involves selling the first shares you bought. In the case of a stock that’s risen in value over time, this will mean that the first shares purchased are the ones you bought at the lowest price — which means for shares held less than one year, you’ll likely pay the higher, short-term capital gains tax. The upside of FIFO is that it’s simple and doesn’t lock you into a cost basis method going forward.

Using specific identification lets you choose precisely which shares to sell, giving you the opportunity to make choices about the capital gain or loss you take on a sale. However, this method requires accurate bookkeeping and an eye for detail, and for every trade using this method, you need to document what shares are being sold.

Average cost may be the easiest method, but it is only available for shares in mutual funds and forces you to continue using the average cost method until you sell all your shares in the fund.

Cost basis is important for tax purposes. When you sell an investment for more than its cost basis, you receive a capital gain and may have to pay taxes on that gain. If you sell for less than the cost basis, you receive a capital loss and, in many cases, can deduct that loss from your income on your tax return, reducing the taxes you owe.

Knowing your investments’ tax basis and managing the tax basis of the investments that you sell can help you manage your investment efficiently, reducing the taxes that you pay.

This article provides a general overview of cost basis but cannot provide all important details. Please consult relevant IRS or professional tax guidance before deciding on a cost basis strategy.