Cost basis is generally your starting tax investment in an asset. After applicable adjustments, your adjusted basis is used to determine gain or loss when the asset is sold.
The basic formula is:
Gain or loss = Amount realized − Adjusted basis
It is important to know the cost basis because if its basis is incorrect you may be overpaying or underpaying your capital gain taxes.
Cost basis is the original value of an asset that is used in tax calculations. In the case of purchased property, the cost basis is frequently the amount you paid for the property, plus a few acquisition costs.
The original basis (after required increases or decreases) is your adjusted cost basis. Qualifying property improvement can increase basis and depreciation can reduce basis, for example.
While these terms are frequently confused, tax basis is the term that is broader than cost basis because an asset’s basis might not be marked to market. There can be special rules regarding inherited, gifted and converted property.
| Term | Meaning |
|---|---|
| Purchase price | What you initially paid |
| Original basis | Starting tax basis, often cost for purchased property |
| Adjusted basis | Basis after applicable increases or decreases |
| Amount realized | Amount used on the sale side of the gain/loss calculation |
| Capital gain/loss | Difference between amount realized and adjusted basis |
Cost basis is a direct consequence on how much capital gain or loss will be reported when the asset is sold. Generally, the more the adjusted basis, the less the taxable gain and the less the adjusted basis, the more the taxable gain.
For instance, if you have an adjusted basis of $12,000 and an amount realized of $20,000, you have a $8,000 gain. If instead you had adjusted basis of $15,000, you would only have a $5,000 gain.
Importantly, the amount of your gain is not the tax rate that will be applied to the gain, rather the cost basis will impact the amount of your gain. The resulting gain will be treated based on the other tax rules, holding period, taxable income, and asset type.
Determine if the asset was bought, inherited, given as a gift, exchanged, or some other means, which may mean different basis rules are in effect.
Original basis for purchased assets typically starts with cost with certain types of acquisition expenses added back.
Include qualifying adjustments, including some capital improvements and any extra acquisition expenses.
Adjustments should be subtracted from, such as depreciation, some reimbursements and deductions.
Adjusted basis = Original basis + applicable increases − applicable decreases
Finally, use:
Gain or loss = Amount realized − Adjusted basis
The outcome is then the basis for deciding upon the proper capital gains tax treatment.
When the tax regulations call for the addition or subtraction of certain amounts from an asset’s original cost, the adjusted cost basis changes. These adjustments are not comprehensive, but are examples of the adjustments that can be applied.
Qualifying acquisition-related capitalized costs and capital improvements are examples of costs that may increase the basis. Real estate – improvements that increase value, useful life, or adapt the real estate to a new use may be allowed as appropriate and as governed by the various rules.
Basis may be reduced due to depreciation, various casualty deductions, reimbursements or other deductions that are required by tax rules.
The concept of depreciation is very relevant in the case of business and rental property. Usually, depreciation decreases basis, which may result in a greater amount of gain being recognized when the property is sold.
| Event | Typical Direction |
|---|---|
| Qualifying capital improvement | Increase |
| Certain acquisition-related capitalized costs | Increase |
| Depreciation | Decrease |
Keeping purchase documents, improvement receipts, depreciation records and other supporting documents ensures that the correct adjusted basis is maintained, and prevents improper gain calculations.
Suppose an asset has the following:
Original basis: $40,000
Qualifying additions: +$8,000
Required reductions: −$3,000
Adjusted basis: $45,000
Amount realized: $70,000
The capital gain is:
$70,000 − $45,000 = $25,000
The $25,000 is the capital gain and not necessarily the capital gain taxes. The actual tax will be based on a number of other factors that will apply to the specific holding period, asset type, tax treatment, income, and gains or losses available.
The cost basis for purchased stocks is typically the price paid, net of any acquisition costs. It is particularly important to have an accurate basis when the same investment is bought at different prices.
The purchase may form a new tax lot, and have a cost basis and acquisition date of its own. Dividends and distributions reinvested can be used to buy more shares, increasing the basis of those shares, and should be accounted for as “additional purchases” not “free” shares.
In a typical stock split, basis will be reallocated among the shares resulting from the split, but the total basis will remain the same. Basis adjustments may also be necessary under various transaction-specific provisions of the Code in connection with mergers, spin-offs and other corporate transactions.
The brokers typically provide the necessary basis reporting on Form 1099-B for covered securities to the IRS and the taxpayers. In the case of noncovered securities, basis might not be reported to the IRS, so taxpayers’ records are especially significant.
A tax lot consists of a collection of securities that were acquired in one transaction, and usually have their own purchase date and basis. If there are several lots, the allowed basis method can impact the gain or loss realized.
| Method | Basic Idea | Main Consideration |
|---|---|---|
| FIFO | Oldest shares are treated as sold first | Basis and holding period of oldest lots |
| Specific identification | Particular shares or lots are identified for sale | Identification and documentation requirements apply |
| Average basis | Uses an average basis where permitted | Availability depends on the investment and circumstances |
FIFO may be used if an alternative allowed for identification method is not correctly applied. Specific identification may be used to choose certain lots, only if certain requirements are met. Some investments, including qualifying mutual fund shares (as defined by IRS rules) have an average basis.
There is no one ‘best’ method. The gains, losses and holding periods of a taxpayer can vary depending on the method used; taxpayers should consult their tax attorney regarding the rules and ensure they have proper transaction records.
For mutual funds and exchange traded funds (ETFs) the cost basis is typically the amount invested in the fund shares, with any necessary adjustments. But it can get tricky to keep track of basis if there are numerous purchases and reinvestments.
The reason for this is that each time a mutual fund is purchased, it forms a new tax lot. Taxpayers may choose to use the specific identification or FIFO or an eligible average-basis method to calculate the basis of shares sold, depending on the investment and circumstances.
Share prices of ETFs are based on securities cost-basis principles. Muliple purchases at various prices result in multiple lots and the shares sold may impact realized gain and holding period.
Dividend distributions and distributions from capital gains typically result in more shares being purchased and can increase your investment basis. These purchases may be overlooked, leading to the reporting of higher gains when shares are sold in the future.
The basis of digital assets is usually determined in terms of U.S. dollars, except for certain methods of acquisition.
The basis for cryptocurrency is normally the cost at which it is acquired, which includes any transaction costs under existing tax law.
The basis calculation may vary depending on the source of digital assets received as a payment, exchange, gift, mining, staking or other means. The basis must thus be determined after identifying the acquisition method.
These units or lots may be different due to the fact that the purchases may be of varying values and may have been bought at different prices and/or dates. Properly identifying the asset may be crucial if the digital asset is sold or otherwise disposed of at a later date.
Keep records of acquisition dates, amounts, and U.S. dollar equivalents, of transaction costs, and of dispositions and of relevant basis adjustments. The rules for digital-asset reporting and basis can be quite involved, so it is advisable to approach this issue in a dedicated cryptocurrency tax guide.
The original basis for purchased real estate begins with the property’s cost and certain settlement and acquisition costs that are to be capitalized are also included.
Basis can be increased with qualifying capital improvements (substantial renovations or additions). In the case of rental property or investment property, depreciation typically reduces adjusted basis, thus raising the gain on sale of the property.
There are special rules for the conversion of personal residence to rental or business use. For example, the depreciation basis does not necessarily have to be the same as the property’s original purchase price, and existing IRS rules and regulations should be reviewed.
Suppose a property has:
Original basis: $300,000
Capital improvements: +$50,000
Depreciation: −$30,000
Adjusted basis: $320,000
If the applicable amount realized is $450,000:
$450,000 − $320,000 = $130,000 gain
Other rules may have an impact on what part of that gain is subject to income taxes.
The structure of inherited property is different than property purchased.
The basis generally is based on the property’s fair market value (FMV) on the decedent’s date of death. There are, however, other special rules and an alternate valuation date in some situations.
A term that is commonly used to simplify the process for inherited property is “step-up in basis,” which will reset the basis of property to its applicable value at the time of the owner’s death. But the basis can theoretically increase or decrease depending on the value of the property from the decedent’s basis.
Estate-tax value information might be available on Schedule A (Form 8971) for beneficiaries of certain estates. The initial basis of the beneficiary may be subject to consistent-basis rules, which would dictate the basis of the stock in the hands of the beneficiary.
The calculation can be altered by alternate valuation elections, estate-tax laws, some property left by a decedent, and other unique situations. The basis for inherited property is highly fact specific – taxpayers should consult current IRS guidance and not presume that the basis is always the date of death basis.
The basis rules apply differently to gifted property because the person who receives the gift does not just use the basis of the property on the date of the gift. The basis might involve the donor’s adjusted basis, the fair market value (FMV) of the asset at the time of the gift and may also include information regarding gift tax paid, depending on the circumstances.
In general, the recipient’s adjusted basis is the basis for determining a gain, with applicable adjustments made. Special dual-basis rules, however, may apply to the case where the asset’s FMV, at the time of the gift, is less than the donor’s adjusted basis.
For example:
Donor’s adjusted basis: $20,000
FMV when gifted: $15,000
The gain is then generally calculated on the $20,000 gain basis and results in a $4,000 gain when the recipient sells for $24,000.
If sold for $12,000, the $15,000 FMV may be used for loss purposes, producing a $3,000 loss.
Special rules might prevent any gain or loss from being recognized if the item is sold for $18,000.
Basis may also be influenced by gift tax and other factors, so it’s best for taxpayers to determine basis according to current IRS guidance.
The concept of cost basis is different from holding period. Basis is the key to gain or loss, and holding period will determine if the gain or loss is Short-Term vs Long-Term.
The longer you hold on to an asset doesn’t necessarily mean your cost basis goes up or down.
There may be special holding period requirements for some assets. For instance, inherited capital assets are deemed to have been held for more than one year for the purpose of determining their sale value, even if the decedent, estate or beneficiary only held the asset for a year. This normally leads to the long-term capital gain or loss treatment.
When cost basis records are not available, it could be more difficult to calculate capital gains, but don’t just estimate basis. Rather, recreate it with trustworthy documentation.
First of all, review your brokerage or investment account for statements, trade histories and trade confirmations. Additional information such as purchase dates, prices, commissions, reinvested distributions, and other information necessary to determine basis may be included on older records.
Look into corporate transactions like stock splits, mergers, spin-offs, and reorganizations as these can alter or effect your original basis.
Extra records may be required for inherited/gifted assets. These may include estate documents, valuation records, donor’s basis information, fair market valuation documentation and applicable tax forms. Special basis rules require the current market value to be used in lieu of the asset, but only after taking into account the special basis rules.
Basis information is required to be reported by brokers for some of the covered securities, and may not be reported to the IRS for noncovered securities.
Form 1099-B might include information on sale proceeds, cost basis, holding period, and if basis was reported to the IRS. This information is typically provided to taxpayers when filling out Form 8949 and Schedule D (Form 1040).
Taxpayer is still responsible to make sure the basis being reported by the broker is correct. Changes may still be required for events and/or information that is not on the brokerage record.
The IRS instructions for the current tax year should be used for the final return as the reporting may change from year to year.
Keeping good records of costs can facilitate the proper calculation of the gain or loss and lend credibility to the numbers on your tax return. Maintain records for as long as required to substantiate the basis (and relevant adjustments) of the asset.
Important records can include:
These records are used to establish the original basis as well as the adjusted basis of an asset when it is sold.
Yes. The higher the Adjusted Basis the smaller will be the capital gain and thus the capital gains tax liability, if any, on that basis. The higher the adjusted basis, the smaller will be the capital gain and, therefore, the capital gains tax liability on that basis, all else being equal.
But a taxpayer may not select or raise his or her basis. Only adjustments allowed by the tax laws are allowed and supporting documentation is crucial.
For investments, an investment tax lot selection may impact the basis applicable to the sale of an investment tax lot. With regard to property, qualifying capital improvements will cause an increase in basis. Other tax-loss or gain planning issues could also impact taxable gains.
The difference is that tax planning relies on options within the tax system, whereas basis manipulation involves reporting unsupported and/or impermissible adjustments. The rules and documented facts always apply to the cost basis.
Cost basis errors can lead to an incorrect capital gain or loss and potentially inaccurate tax reporting. Common mistakes include:
A good cost basis calculator should gather sufficient data to calculate the original basis of the asset as well as any basis adjustments.
Recommended inputs include:
First and foremost, a calculator needs to branch based on the method acquired. There are different basis rules for purchased, inherited and gifted assets. If a calculator used the same “purchase price plus improvements” on all assets, it could result in inaccurate results.
The typical starting tax investment in an asset is its cost basis. The adjusted basis, after application of these adjustments, is what is used to measure the capital gain or loss on the sale of the asset.
Use the original basis, plus any increases, minus any decreases as required:
Adjusted basis = Original basis + increases − decreases
A cost basis is typically the initial basis of the asset, in this case usually the cost of the asset. The subsequent increases or decreases required under tax rules is “adjusted cost basis.”
In most cases, the taxable gain, rather than the sale proceeds, are subject to Capital Gains Tax. The amount of gain is the difference between adjusted basis and amount realized.
Basis can be increased by qualifying acquisition costs, capital improvements, and other selected capitalized expenses, depending on the type of asset. The costs eligible depend on the applicable rules.
In general, shares bought in the company at various times and different prices form different tax lots. The basis applied will be based on whether or not specific basis methods (such as FIFO or specific identification) are applied to certain shares.
Review brokerage statements, trade confirmations, property records, etc. and historical records. Reconstruct the basis with reliable evidence, but not guessing or with an unsupported amount.
Usually, a stock split will re-split your overall basis among the shares issued. The total basis is generally not adjusted and the per-share basis is adjusted.
The basis enjoyed by an inherited asset is normally the fair market value at the date of the decedant’s death. But other special rules and alternate valuation elections may apply.
Gifted property basis may be based on donor’s adjusted basis, fair market value at the time of the gift and, possibly, gift tax. There may be different basis rules for determining a gain versus a loss.
Generally, yes. Typical depreciation allowed or allowable on rental property will generally decrease the adjusted basis of the property, thereby increasing the gain on the sale of the property.
Brokers in most instances will report cost-basis information to the Internal Revenue Service (IRS) and to the investor on forms such as Form 1099-B for covered securities, but not in the case of noncovered securities, and the basis of the securities will be the responsibility of the taxpayer.
One of the most significant numbers when determining capital gains or capital losses is the cost basis. Your adjusted basis – It is your original basis plus applicable increases or decreases.
At the time of sale the basic computation is:
Gain or Loss = Amount realized − Adjusted basis
The larger the legitimate adjusted basis the smaller the gain; the smaller the basis, the larger the gain. But, basis is not the tax rate for capital gains. The resulting gain will be treated based on the other tax rules, holding period, taxable income, and asset type.
The calculations for stocks bought in several separate lots, reinvested distributions, rental property, depreciation, gifts, inheritances and corporate actions can turn more complex. It can make these calculations much easier if you keep proper records of your purchases, brokerage statements, receipts for any improvements, and other related documents.
Cost-basis and reporting may differ depending on the type of asset and acquisition, so do not use estimates without supporting information. For complex inherited or gifted property, or for major transactions, please seek to the current IRS guidance or a qualified tax professional before filing.