Cost Basis: Exchange of Convertibles for Common Shares
When a convertible bond or convertible preferred stock is converted into common stock, the conversion itself is not a taxable event. The cost basis transfers directly to the new shares.
Conversion of Convertible Bonds
The core rule: When a convertible bond is converted to common stock, the cost basis of the common shares equals the cost basis of the bond.
- The conversion is not a taxable event - no gain or loss is recognized
- Cost basis per share = bond cost basis / number of shares received
- The holding period of the bond tacks on to the common stock
Exam Tip: Gotchas
- Conversion is never a taxable event. Tax consequences only arise when the common shares are eventually sold.
- The holding period carries over. If you held the bond for 14 months before converting, the common shares are already long-term from day one.
Calculation examples:
| Bond Purchase Price | Conversion Ratio | Shares Received | Cost Basis Per Share |
|---|---|---|---|
| $1,000 (at par) | 50:1 ($20 conversion price) | 50 shares | $1,000 / 50 = $20.00 |
| $900 (at discount) | 50:1 ($20 conversion price) | 50 shares | $900 / 50 = $18.00 |
| $1,100 (at premium) | 50:1 ($20 conversion price) | 50 shares | $1,100 / 50 = $22.00 |
The Key Distinction: Conversion Price vs. Cost Basis
This distinction is frequently tested:
- The conversion price ($20 in the example above) determines how many shares you receive. It is based on the bond's par value ($1,000 / $20 = 50 shares)
- The cost basis per share depends on what the investor actually paid for the bond, not par value
If you paid $900 for a bond that converts at $20 per share (50 shares), your cost basis per share is $18 - not $20.
Exam Tip: Gotchas
- Conversion price sets the share count (based on par value). Purchase price sets the cost basis per share. If a bond bought at $900 converts at $20 (50 shares), the cost basis per share is $18, not $20.
Convertible Preferred Stock
The same rules apply:
- Cost basis of the preferred stock transfers to the common shares received
- No taxable event upon conversion
- Holding period of the preferred tacks on to the common stock
Think of it this way: Whether you start with a convertible bond or convertible preferred, the tax logic is identical. The IRS treats conversion as a change in form, not a sale. You bought an investment, and now it looks different, but you have not cashed out. Tax only matters when you eventually sell the common shares.