Cost Basis Requirements

You've learned how to measure returns; now you need to understand how the IRS tracks what you paid for your investments. Cost basis is the starting point for calculating capital gains and losses when you sell.

What Is Cost Basis?

Cost basis is the original value of an investment for tax purposes. For shares you buy, it is typically the purchase price plus commissions and fees. Shares you inherit or receive as a gift follow different rules (see Inherited and Gifted Shares).

• Used to determine capital gains or losses when the investment is sold
• Capital gain = Sale price - Cost basis (if positive)
• Capital loss = Sale price - Cost basis (if negative)

Example, Cost basis:

• You buy 100 shares for $5,000 ($50/share) plus a $10 commission
• Your cost basis = $5,000 + $10 = $5,010

Example, Capital gain:

• Your cost basis is $5,010
• You sell for $6,000
• Your capital gain = $6,000 - $5,010 = $990

Adjusted Cost Basis

Adjusted cost basis accounts for events that change your original cost:

Example, Stock split:

• You own 100 shares with a $5,000 basis ($50/share)
• 2-for-1 stock split
• You now own 200 shares with a $5,000 basis ($25/share)

Example, Return of capital:

• You own shares with a $10,000 basis
• You receive $2,000 in return of capital distributions
• Your adjusted basis = $10,000 - $2,000 = $8,000

Example, Sale after return of capital:

• Your adjusted basis is $8,000
• You later sell for $10,000
• Your gain = $10,000 - $8,000 = $2,000 (not $0)

Think of it this way: A return of capital is not income; it is a return of your own money. Since you already got some of your investment back, the IRS lowers your cost basis so you cannot claim that portion as a loss later.

Exam Tip: Gotchas

• Return of capital reduces cost basis, which increases the taxable gain when you eventually sell.
• Stock splits and stock dividends do NOT change total cost basis. Only per-share basis changes.
• Reinvested dividends increase cost basis because you are buying additional shares.
• Total cost basis always rises with each reinvestment, since every reinvestment is a new purchase. But the average per-share cost basis can go up or down: a reinvestment at a price below your prior average pulls the per-share average down, even though total dollars invested still went up.
• Once return of capital reduces basis to zero, further distributions are taxable as capital gains.

Inherited and Gifted Shares

Not every investor buys their shares. When shares are inherited or received as a gift, a different rule sets the starting basis, and the purchase-price definition above does not apply.

Example, Inherited mutual fund:

• Your aunt paid $12,000 for fund shares and reinvested $3,000 of capital gains distributions, so her basis was $15,000
• On the date she dies, her shares have a NAV of $40,000
• Your cost basis = $40,000 (not $12,000 and not $15,000)
• If you sell for $42,000, your gain is $2,000, and it is long-term even if you sell a week later

Example, Gift:

• Your uncle paid $12,000 for shares and gives them to you when they are worth $40,000
• Your cost basis is generally $12,000, because his basis carries over to you
• If you sell for $42,000, your gain is $30,000

Think of it this way: An inheritance resets the clock and the price tag to the day of death. A gift hands you the donor's price tag along with the shares.

Exam Tip: Gotchas

• Inherited shares do NOT keep the deceased owner's cost basis. The heir's basis is the fair market value (for a fund, the NAV) on the date of death.
• Do not add the deceased owner's past dividends or capital gains distributions to an inherited basis. The date-of-death value replaces the old basis entirely.
• The date of death is the default valuation date. The executor may elect an alternate valuation date, generally 6 months after death, but only if the election lowers both the value of the estate and the estate tax. No rule values inherited shares 30 days after death.
• Inherited shares are treated as long-term for capital gains, even if the heir sells them within a year.
• Gifted shares generally keep the donor's basis, so the donor's built-in gain passes to the person who received the gift.

Cost Basis Methods for Mutual Funds

When you own multiple lots of the same mutual fund (bought at different times and prices), you need a method to determine which shares you're selling:

FIFO example:

• Lot 1: 50 shares at $20 (bought January)
• Lot 2: 50 shares at $30 (bought June)
• You sell 50 shares at $35
• Under FIFO, you sell the January shares first: gain = $35 - $20 = $15/share

Exam Tip: Gotchas

• FIFO (First In, First Out) is the IRS default method. If no method is elected, the oldest shares are sold first.

Broker-Dealer Reporting Requirements

• Broker-dealers are required to track and report cost basis to the IRS for covered securities (most securities bought in recent years)
• Reported on Form 1099-B
• For non-covered securities (generally older holdings bought before broker reporting was required), the investor is responsible for tracking their own cost basis

What Should You Check on Exam Day?

• Can you explain how a stock split affects total versus per-share cost basis, and why reinvested dividends increase total cost basis?
• Can you state the cost basis of inherited shares (fair market value, or NAV for a fund, on the date of death) and of gifted shares (generally the donor's basis)?
• Can you state which cost basis method the IRS uses by default when no method is elected?
• Do you know what happens to further return of capital distributions once basis reaches zero?
• Can you explain the difference between covered and non-covered securities for cost basis reporting?