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, typically the purchase price plus commissions and fees.
- 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:
- You buy 100 shares at $50/share plus a $10 commission
- Your cost basis = (100 x $50) + $10 = $5,010
- If 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:
| Event | Effect on Cost Basis |
|---|---|
| Stock split | Total basis stays the same; per-share basis decreases |
| Stock dividend | Total basis stays the same; per-share basis decreases |
| Return of capital | Total basis decreases |
| Reinvested dividends | Total basis increases (you bought more shares) |
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
- If you later sell for $10,000, your gain is $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.
- Once return of capital reduces basis to zero, further distributions are taxable as capital gains.
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:
| Method | How It Works | Key Facts |
|---|---|---|
| FIFO (First In, First Out) | Oldest shares are sold first | IRS default method |
| Specific identification | Investor selects which specific shares to sell | Maximum tax control; must identify shares at time of sale |
| Average cost | Total cost divided by total shares | Simplest calculation; commonly used for mutual funds |
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
Average cost example:
- Same lots as above: total cost = (50 x $20) + (50 x $30) = $2,500
- Average cost per share = $2,500 / 100 = $25/share
- Sell 50 shares at $35: gain = $35 - $25 = $10/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
- Covered securities are those acquired after specific effective dates:
- Stocks: acquired after January 1, 2011
- Mutual funds and exchange-traded funds (ETFs): acquired after January 1, 2012
- Bonds and options: acquired after January 1, 2014
- Reported on Form 1099-B
- For non-covered securities (acquired before these dates), the investor is responsible for tracking their own cost basis