# What Is Cost Basis?

Cost basis, also referred to as tax basis, is the purchase price of an asset. It is also used to determine the profit or losses when that asset is sold.

There are many factors that can determine the cost basis of an investment or asset, such as sale price, how the asset/investment was acquired, and the length of time the asset has been held.

## Why Is Cost Basis Important?

The Internal Revenue Service (IRS) requires that capital gains or losses are reported. Cost basis becomes important when needing to detail this information.

It’s also an important factor in figuring out how well your investments are performing. Investors will use cost basis to help minimize taxable gains by figuring out which shares have had the highest cost basis since they were obtained.

### Capital Gain

The simple definition of a capital gain is an increase in an asset’s value since it was initially purchased or acquired. This value is usually obtained once the asset or investment has been sold. It can be over a short-term (less than 12 months) or long-term (greater than 12 months) basis, depending on the length of time the asset was held.

Capital gains can be calculated using the following formula, assuming the price of the asset is higher when sold than when purchased:

PRICE WHEN SOLD – PURCHASE PRICE = CAPITAL GAIN

If the price of an investment/asset has decreased more when it is sold than when it was purchased, an investor would report a capital loss.

### Tax Reporting Cost Basis

As mentioned above, capital gains and losses must be reported as required by the IRS. However, capital gains are only determined once an asset has been sold. Therefore, it is important to keep detailed records of cost basis.

It will also depend on how the asset was acquired and how long it was held onto prior to being sold. Another factor to consider when determining capital gains is what tax bracket you are in.

## Methods Using Cost Basis

Depending on the type of asset that was acquired, there are different methods for determining cost basis. Two common methods are average cost basis method and cost basis comparison. Let’s review these below.

### Average Cost Basis Method

Using the average cost basis method is most common when calculating the value of mutual funds. As we know now, the cost basis of a mutual fund is determined when the mutual fund was initially acquired.

To determine the average cost basis, you would divide the total amount that was invested in the mutual fund by the number of shares that are owned. For example, if \$5,000 was invested in a mutual fund and you own 50 shares, the average cost basis would be \$100 (\$5000/50=\$100).

There are other methods available to determine the average cost basis. These can include the first in, first out (FIFO) method, the last in, first out (LIFO) method, high cost method, and low cost method. The FIFO method, much like it sounds, means that when selling your assets or shares you have to sell the first ones that you purchased. This can become important if an asset has become long-term, as it can lead to lower taxes to be paid.

The last in, first out (LIFO) method can be applied when an investor wants to sell the shares that were purchased most recently, but hold on to the shares that were initially purchased. This could be due to the fact that the initial shares were purchased at a lower price than the more recent shares.

### Cost Basis Comparison

Using cost basis comparison can become important if an investor purchased numerous shares at different prices. To determine the cost basis, you would compare the purchase prices at each moment the shares were purchased to determine an average cost.

That amount would then be subtracted from the price at the moment an investor decides to sell a portion of the total shares that were acquired.

### Example of Cost Basis Comparison

Let’s go through an example of using cost basis comparison. Suppose an investor purchased shares in the following order: 100 shares at \$5/share, 50 shares at \$2/share, and 10 shares at \$1/share. Average cost basis would be determined by figuring out the average cost:

(100 x 5) + (50 x 2) + (10 x 1) = \$610. You would then take the average cost and divide it by the total number of shares:

\$610/160 shares = \$3.81. This value is the average cost basis.

If the investor then decided to sell 10 shares at the current price of \$6/share, the average cost basis would be determined by \$6 – \$3.81 = \$2.19. They would take the 10 shares to be sold and multiply that by the average cost basis subtracted from the new price it is selling for, leaving the investor with a capital gain of \$21.90:

\$2.19 x 10 = \$21.90.

However, capital gain can be affected by which method the investor decided to use and when. The value can be significantly different if the investor decided to use FIFO, LIFO, high cost, or low cost methods.

## Stock Splits & Cost Basis

Now that we know what cost basis is and how to calculate it, what does it mean if a company decides to split their stocks? This can happen when a company wants to lower the price of their shares to make them more appealing to investors.

Stock splitting occurs frequently with large companies that are increasing profits; when their stock price increases too much, they decide to split their stock to help lower their purchase price.

### What Are Stock Splits?

There are two ways to split stocks; forward split and reverse split. Most commonly, a company will use the forward split. This means that they take their existing number of shares and split them into multiple new shares. Common splits are 2:1 or 3:1, however, a company can split their shares into any number they choose.

The good news is that if you own a number of shares in a company when they decide to split their stocks, it will not affect your total cost basis. However, you will see a decrease in the cost basis per share.

### Examples of Stock Splits & Cost Basis

Let’s say that you own 100 shares of company XYZ at a purchase price of \$50/share, meaning you had \$5,000 invested. The current price per share of company XYZ is now \$75/share, so your investment increased to \$7,500 (\$75 x 100 = \$7,500).

Company XYZ decides to split their stock 2:1. That means that for every share you own, you now own 2 shares. Their current price changes to \$37.50/share. Instead of owning 100 shares, you now own 200 shares. Your cost basis will still be \$7,500 (\$37.50 x 200 shares = \$7,500).

However, you will notice that although your total cost basis remains the same, your price per share decreases (\$5000 / 200 shares = \$25/share).

## Mergers & Cost Basis

Now, what happens to cost basis if the company you invested in merges with another company? If this happens, the purchasing company will most likely issue stock, cash, or a combination of both, to existing shareholders of the company being purchased. Of course, this will depend on the type of merger that has taken place between the two companies.

### What Are Mergers?

Simply stated, a merger is when two companies come together to form one new company. There are several types of mergers, including conglomerate, product extension, market extension, horizontal, and vertical. Depending on what company you invested in (acquiring company or target company), you may see a slight change in the initial cost basis of your investment.

### Examples of Mergers & Cost Basis

As mentioned above, the different types of mergers include:

• Conglomerate merger: When two or more companies that have little in common and operate across several different industries come together.
• Product extension: Also known as congeneric, is when two companies with similar products and within the same industry merge.
• Market extension: When two companies that have the same products but operate within different markets come together.
• Horizontal merger: A merger between companies within the same industry.
• Vertical merger: When two companies with different goods or services merge to offer one specific product together.

When a company that you own shares in mergers with another company, you will need to determine your cost basis to figure out any gains or losses. To do this, you will need to determine the number of shares that you have now acquired due to the merger.

## Inherited Shares & Cost Basis

We’ve discussed how the cost basis of an investment can depend on how the investment was acquired. One way that someone can obtain shares in a company is by inheriting those shares. If stock is inherited, the cost basis will change.

### What Are Inherited Shares?

Inherited shares are shares of stock that a person obtains through an inheritance. In this instance, the cost basis will not be based on the market value at the time the shares were originally purchased.

Instead, the cost basis of the shares is going to change based on the market value on the date that the shares were inherited.

### Examples of Inherited Shares & Cost Basis

The difference between the original cost of the shares and the cost at the time of an inheritance is not taxed. In other words, the person that inherited the stock is only responsible for capital gains acquired during their lifetime.

Let’s say Joe inherited 100 shares of company ABC on today’s date. The purchase price of the shares on today’s date is \$25/share. When the shares were initially obtained by Joe’s family member, the purchase price was \$100/share.

If Joe decided to sell the shares upon inheriting them, the cost basis would be \$25/share, even though the shares were originally purchased by Joe’s family member for \$100/share.

## Futures Contract & Cost Basis

Understanding cost basis allows investors to exchange futures contracts based on when they feel the direction of the shares they want to purchase will offer the best capital gains. The goal when trading futures contracts is to obviously avoid any losses. Of course, this is a risk associated with investing in futures contracts.

### What Are Future Contracts?

Futures contracts are legal contractual agreements to buy or sell an asset in the future for an already agreed upon price. These assets or commodities can be metals, grains, oil, and U.S. and foreign currencies. The contracts come with expiration dates which are agreed upon at the time of purchase.

### Examples of Future Contracts & Cost Basis

Understanding how to calculate the cost basis of an asset allows investors to enter into future contracts, as well as when to sell those contracts. For example, let’s say an investor decides to enter into a futures contract for bushels of wheat in January, with the expectation that it will become profitable by mid-year. The futures contract for bushels of wheat is going for \$25 at the time the contract is locked in.

Wheat is typically traded in bushels of 5,000. Therefore, the investor has \$25 x 5,000 for a total of \$125,000. This amount is not expected to be paid all at once, up-front. The investor is able to pay an initial margin of that amount.

Now, it’s June and the contract is about to expire and the investor is ready to sell. The price of wheat at this time has increased to \$30. The investor would have earned \$25,000 ([\$30 – \$25 = \$5] x 5,000 = \$25,000). The same principle applies had the price of wheat dropped to \$20; however, it would have been a loss to the investor.

## Dividends & Cost Basis

We’re starting to see that costs basis can be influenced by a number of different factors. Another one of these factors can include if a company decides to pay out dividends to its shareholders. Let’s review dividends and then look at an example of how it is related to cost basis.

### What Are Dividends?

A dividend is a portion of a company’s profits that are paid out to shareholders, usually at an amount agreed upon by a board of directors. Dividends can be cash payments or additional shares of stock. It’s important to note that not all companies will pay dividends, as some will choose to reinvest their profits back into the company.

### Examples of Dividends & Cost Basis

It is important to understand cost basis and how it can be affected by a company paying out dividends. For example, let’s say company XYZ announces they are going to pay a \$5 dividend on June 1. They are trading at \$55 per share when this announcement is made. This causes the share price of XYZ to increase to \$60 per share.

Now, let’s say the stock then trades at \$65 per share with one day left until the dividends are paid out. On June 1, the stock would then be adjusted to reflect the dividend, which would cause it to trade at \$60.

If you were to purchase 10 shares just prior to the dividend announcement, your cost basis would have been 10 x \$55 = \$550. If you were to purchase 10 shares post dividend payout, your cost basis would be 10 x \$60 = \$600.

## Benefits and Drawbacks of Cost Basis Method

As with anything when it comes to investing, there are benefits and drawbacks to using the cost basis method. It is important to understand cost basis and how best to use it in order to maximize your potential profits.

### Benefits

Cost basis is beneficial in allowing investors to know whether their investment has earned them a profit or a loss. Once you understand it, it can be very easy to use. It can also assist investors with knowing when to sell or trade their assets, as they are going to be looking for moments when they can make the most capital gains.

### Drawbacks

There are certain drawbacks to using cost basis methods, depending on the method you choose. Some cost basis methods may not recognize gains or losses, which can be harmful for tax reporting purposes. It is very important to keep detailed records of your assets to be sure you are accurately reporting your gains and losses to the IRS.

## Understanding Cost Basis

Understanding cost basis can appear complicated if you do not factor in all of the different investment strategies that can affect it. Knowing that cost basis is the price of an asset on the date the asset is purchased is the first step.

While many factors can contribute to the cost basis of an asset, it’s important to know there are always options available to help you. Consulting with a financial advisor can assist you in not only understanding cost basis, but also with knowing when to purchase, sell, or trade your investments.