Cost of Investing in Securities
The cost basis of an investment is the original value of an asset, adjusted for stock splits, dividends, and capital distributions. It is a crucial figure used to determine capital gains or losses for tax purposes.
At its most basic, cost basis refers to the total amount invested in a security, including any commissions paid at the time of purchase. This can be expressed either as a total dollar amount or as a per-share price. For example, if you invest $10,000 in a company and pay a $100 commission, your total cost basis is $10,100.
Let’s explore this further with an example. Suppose you invest $10,000 in ABC Inc. and receive 1,000 shares. Your cost basis is $10,000, or $10 per share. A year later, the share price increases to $15, and you decide to sell. Your investment is now worth $15,000, resulting in a $5,000 capital gain ($15 - $10 × 1,000 shares), which is subject to capital gains tax.
How Stock Splits Affect Cost Basis
Stock splits affect your per-share cost basis but not the total value of your investment. Using the same example, imagine ABC Inc. declares a 2-for-1 stock split. You now hold 2,000 shares instead of 1,000, but the total investment value remains $10,000. Your new per-share cost basis becomes $5, calculated in one of two ways:
- Divide the original investment amount by the new number of shares: $10,000 ÷ 2,000 = $5
- Divide the original per-share cost basis by the split factor: $10 ÷ 2 = $5
Adding More Shares at a New Price
If you invest another $10,000 when the share price is $5, you will acquire an additional 2,000 shares. Now you hold a total of 4,000 shares with a mixed cost basis:
- 2,000 shares at $5 (new purchase)
- 2,000 shares at $5 (after the split)
Your overall cost basis is now $20,000.
Selling Shares: FIFO and Share Identification
When selling shares, the Internal Revenue Service (IRS) allows you to specify which shares you’re selling, enabling you to choose those with the highest or lowest cost basis. However, if you can't identify the specific shares, you must use the First In, First Out (FIFO) method.
For instance, if you sell 1,500 shares:
- The first 1,000 are assumed to be from the original purchase at $10/share (before the split).
- The next 500 shares come from the $5/share group.
This leaves you with 1,500 shares at $5/share for future sales.
Gifted and Inherited Shares
If you receive shares as a gift, your cost basis is generally the same as that of the person who gave you the shares. If the market value has decreased since the original purchase, and you sell the shares at a loss, the lower market value at the time of the gift becomes your cost basis.
For inherited shares, the cost basis is the fair market value of the shares on the date of the original owner's death, regardless of their purchase price.
Final Thoughts
Calculating cost basis can become complex, especially when multiple purchases, stock splits, gifts, or inheritance are involved. Given its importance in determining your tax liability, it’s wise to consult a financial advisor, accountant, or tax professional if your cost basis is unclear.
