What Is Cost Basis & Why Should You Know It?

Savvy investors know how to manage cost basis and holding periods of their investments to help reduce capital gains that are subject to taxes, or even to claim a tax loss when selling a profitable position. Knowing your cost basis can be a valuable tool.

 

What Is Cost Basis?

The cost basis of any investment is the original value of an asset adjusted for stock splits, dividends and capital distributions. It is used to calculate the capital gain or loss on an investment for tax purposes.

At the most basic level, the cost basis of an investment is just the total amount invested into the company plus any commissions involved in the purchase.

The calculation of cost basis can be complicated due to the many changes that will occur in the financial markets such as splits and takeovers. Your capital gain (or loss) will be the difference between the cost basis and the price at which you sell your securities. This cost is relatively easy to calculate assuming you don’t reinvest dividends or dollar-cost average when you invest.

Why Should You Know Your Cost Basis?

Over time, specifically if you participated in a dividend reinvestment plan or purchased shares over multiple periods of time, you will have multiple cost basis and multiple holding periods for each block of shares. Thus, you could pick and choose among the high, or low-cost basis and the long or short-term shares when you sell, and make the sale work to your best tax advantage. You can go with the automatic default method (of your broker), which requires zero effort or calculation on your part—but that could cost you more in taxes. 

What Are the IRS Rules Regarding Cost Basis?

The accounting method the IRS will assume for both stock and mutual fund sales is called FIFO, or “first in, first out.” If, for example, you sold 200 shares of an 800 share holding, the IRS will assume that the shares you sold were the first you bought. Those, of course, are likely to have the lowest cost and the highest tax obligation, assuming a rising market.

A better option for investors is to specify a method that would produce the lowest tax liability possible.

How Do You Identify the Specific Shares You Want To Sell?

If you are trading online, the approach will vary by brokerage. Some of the available methods are the LIFO method, Highest Cost, Lowest Cost, Average Cost and Specific Lot Method. The Specific Lot Method allows you to hand pick exactly which lots you want to sell. This method is more hands on than the rest since you pick which tax lots get sold each time you sell shares. It’s also the most tax efficient because it offers the best chance to control your tax bill each year.

By hand picking a specific lot, you can adjust your yearly long and short-term capital gains and losses on every sale. The specific lot method offers the best financial outcome since it forces you to be actively aware of your investments and tax liability.

Once shares are sold you cannot retroactively change your cost basis method from the default method you selected. Therefore, it’s best to set your method of choice before you start selling off shares. This way you won’t unknowingly lock yourself into a bad decision.

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