Understanding Cost Basis: Calculation, Examples, and Tax Impact

What is cost basis?

Cost basis (or tax basis) is the original value of an asset for tax purposes, typically the purchase price plus any purchase-related commissions or fees. It is the starting point for calculating capital gains or losses when you sell an asset and may be adjusted over time for events such as stock splits, reinvested dividends, return of capital distributions, and certain corporate actions.

Key takeaways

• Cost basis determines taxable capital gain or loss when an asset is sold.
• Reinvested dividends and capital gains increase cost basis and reduce taxable gain.
• Different cost-basis methods (FIFO, LIFO, average cost, high-cost, low-cost) can produce materially different tax outcomes.
• Stock splits change per-share basis (not total basis). Gifted and inherited shares follow different rules.
• For futures, cost basis is the difference between spot and futures prices and can be positive or negative.
• Keep good records and consult a tax advisor for complex situations.

How cost basis affects your investments

• Reinvested dividends and distributions are treated as additional purchases and increase your cost basis. Failing to include them can cause you to overstate gains and pay excess tax.
• Brokerage firms report cost-basis information on tax forms and typically allow you to select a cost-basis method. For mutual funds, many brokers default to average cost; once elected for a mutual fund, that method usually must remain in effect.
• Accurate basis tracking is essential for correct tax reporting and measuring after-tax investment performance.

Example: calculating adjusted cost basis

Example:
* Initial purchase: 100 shares for $1,000.
* Reinvested dividends over two years: $100 and $200.
* Adjusted cost basis when sold: $1,000 + $100 + $200 = $1,300.

If you sell the shares for $1,500:
* Taxable gain = $1,500 − $1,300 = $200.
If you ignored the reinvested dividends and used $1,000 as the basis, taxable gain would incorrectly be $500.

Comparing cost-basis methods

Different accounting methods can change reported gains or losses. Example holdings:
* 1,500 shares at $20 = $30,000
* 1,000 shares at $10 = $10,000
* 1,250 shares at $8 = $10,000
Total cost = $50,000 for 3,750 shares → average cost = $13.33 per share.

If you sell 1,000 shares at $19:
* Average cost method: (19 − 13.33) × 1,000 = $5,670 gain
* FIFO (first in, first out): (19 − 20) × 1,000 = −$1,000 loss
* LIFO (last in, first out): (19 − 8) × 1,000 = $11,000 gain
* High-cost (sell highest-cost lots first): same as FIFO here = −$1,000
* Low-cost (sell lowest-cost lots first): same as LIFO here = $11,000

Takeaway: choice of method affects tax liability. For mutual funds, average cost is common and often required once elected. For taxable accounts with separate lots, you may be able to specify lots at sale (share identification) to manage tax outcomes.

Adjusting basis after stock splits and corporate actions

• Stock split: total basis remains the same; per-share basis is divided by the split factor.
• Example: $10,000 total basis for 1,000 shares ($10 per share). After a 2-for-1 split you hold 2,000 shares; new per-share basis = $10,000 ÷ 2,000 = $5.00.
• Other corporate actions (reverse splits, spin-offs, returns of capital) similarly adjust basis—track broker statements and company notices.

Gifted and inherited shares

• Gifted shares: generally adopt the donor’s cost basis. Special rules apply if the share’s fair market value at the gift date is lower than the donor’s basis—consult a tax professional for specifics.
• Inherited shares: basis typically “steps up” (or down) to the market value on the decedent’s date of death (or alternate valuation date), which can reduce taxable gains on a later sale.

Cost basis in futures contracts

• For commodities, basis = spot price − futures price (or vice versa, depending on convention). It can be positive or negative.
• Example: futures price $3.50 vs spot $3.10 → basis = $0.40.
• Basis reflects local market conditions and converges toward zero as futures approach delivery.

Cost basis vs tax basis

• Cost basis is the original acquisition cost (plus fees).
• Tax basis often refers to the adjusted cost basis at the time of sale (after adjustments for reinvested income, splits, depreciation, etc.). Capital gains tax is calculated as sale proceeds minus the adjusted basis.

How the IRS verifies basis in real estate

• For real estate, the IRS can verify cost basis using closing statements (HUD-1), settlement statements, purchase contracts, mortgage documents, and other legal records associated with the purchase. Keep closing paperwork and records of capital improvements that increase basis.

FAQs

Q: Can I change my cost-basis method after choosing one?
A: For many asset types—especially mutual funds—your chosen method may be required to remain in effect for that holding. Rules vary by asset and broker; check with your brokerage and tax advisor.

Q: What happens if I don’t track reinvested dividends?
A: Omitting reinvested distributions typically understates your basis and overstates taxable gains, which can cause you to pay more tax than necessary.

Q: When should I consult a professional?
A: Consult a tax advisor or CPA for complex situations: large portfolios with many lots, inherited or gifted property, real estate with capital improvements, or unusual corporate actions.

Bottom line

Cost basis is the foundation for calculating capital gains and losses. Keep thorough records of purchases, reinvested distributions, and corporate events; choose and document an appropriate cost-basis method; and consult a tax professional when basis is unclear or complex to ensure accurate tax reporting.