If you plan on selling investments this tax year or in the future, it’s time to get acquainted with cost basis. But what is cost basis, why does the Internal Revenue Service (IRS) care about it, and how does it affect your income tax return? Let’s break it down together by looking at some frequently asked questions about cost basis.
At a glance:
Cost basis is the value of an asset for tax purposes.
An item’s basis is generally its purchase price plus any necessary adjustments.
There are different methods for calculating cost basis; each can prove beneficial depending on your specific tax situation.
What is cost basis?
Your cost basis is the value of an investment for tax purposes. This amount will determine your profit or loss when selling the investment. The investment can be anything, including your house, car, stocks, or a collectible or antique you’re selling online.
Generally, your cost basis is the purchase price of an asset; however, adjustments can be made depending on your situation and the type of investment. For example, if you paid commissions or fees when purchasing an asset, these can be added to your cost basis.
What expenses can be included in the cost basis?
Any costs you incur that increase the value of your asset can generally increase your cost basis. For example, say you are a homeowner and recently renovated your kitchen, adding to the value of your home before selling. If you sell your home, your renovation expenses can be added to your home’s original cost basis.
You can also include the costs of selling an asset to adjust your basis. Continuing with the homeowner example, you can use costs tied to the sale of your home to increase your basis and reduce your gain. Examples could include legal fees and commissions paid to your realtor.
Why do I need to know the cost basis of an asset?
Cost basis comes into play when you sell an asset for a profit or loss. It’s used to determine your capital gain or loss for tax purposes. Capital gains are taxed as income, and capital losses can be used to offset your gains. The tax rate depends on whether it’s a long-term capital gain or a short-term gain. Long-term gains have special tax rates, while short-term gains are considered ordinary income and taxed as such.
To determine your taxable gain, use the following formula:
Sale Price – Cost Basis = Capital Gain
Cost basis reporting is also necessary when you claim a tax credit or other tax break based on it, such as the depreciation deduction.
Adjusted cost basis vs. original cost basis
Your original cost basis is generally an asset’s purchase price. Adjusted basis is an asset’s cost basis that has been adjusted for various reasons. As we previously mentioned, certain events can increase your basis, such as commissions or fees, while other events can decrease your basis, like taking a depreciation deduction for your property.
How do I determine the cost basis of my car if I had a trade-in?
If you trade in a car or truck, your cost basis in the new vehicle is simply your basis in the old one plus the amount you paid with the trade-in.
For example, let’s say you have a car with a basis of $2,000. You trade it in for a new car and pay $20,000 cash in addition to your trade-in credit. The basis in your new vehicle is $22,000 ($2,000 + 20,000 = $22,000).
I sold mutual fund shares last year. Do I need to adjust my basis?
When you own mutual funds, you may pay tax on reinvested dividends and capital gains distributions during any holding period. You don’t want to pay tax on those dividends and gains again when you sell the mutual fund shares. To avoid this, you need to increase your mutual fund shares basis by the amount of any dividends and gains on which you’ve paid tax.
In this instance, there are different methods for calculating cost basis, which we will discuss more in the next section.
I sold only part of my stock in a company, which I bought at different times and different prices. How do I determine my cost basis?
You can use different cost basis methods depending on which is more beneficial for your situation.
If you sold only some of your shares in a company but didn’t tell your broker which stocks you sold, you would often use the first-in, first-out method (FIFO) as the default method to calculate your cost basis. The IRS requires you to assume that you sold your oldest stocks using this method. Unfortunately, your oldest stocks might have the lowest cost basis and may not be the best tax result for you.
If you’d rather sell other stocks from a particular company, you must tell your broker beforehand and get confirmation from your broker about which stocks you sold.
There are also other ways to calculate your cost basis that may be more beneficial for you. For example, the average cost method divides the total cost of all your shares by the number of shares (commonly used for mutual funds). Another method is the specific shares method, in which you select which shares to sell, giving you more control over which cost basis you want to use. You can also choose last in, first out (LIFO) and more options.
What are some other reasons I may need to adjust my cost basis for tax reporting?
Some other reasons for adjusting cost basis include the following:
Stock splits
A stock split happens when a company increases its number of outstanding shares (shares not held by the company). A split doesn’t change your total cost basis as a shareholder, but it can change the cost basis per share. If a stock splits and you sell less than 100% of your shares, you’ll need to adjust your cost basis for the split to calculate your basis correctly. The same is true if the stock has a reverse split, which is the opposite — when a company lowers its outstanding shares.
Depreciation
You’ll also need to lower your cost basis if you receive tax benefits for an asset. For example, taking a depreciation deduction for your real estate investment reduces the cost basis of that real estate. To adjust your cost basis for depreciation, look at your tax returns, starting with the year you purchased an asset. Add together all the depreciation taken for the asset and reduce your basis by that amount.
With all these different calculation methods, it never hurts to consult a tax professional to determine which would be more beneficial for your tax situation. For more detailed information, check out IRS Publication 551, Basis of Assets.
FAQs
The bottom line
Understanding your cost basis is the first step to figuring out your true investment gains and avoiding unnecessary taxes. Whether you’re selling stocks, real estate, or other assets, knowing how to calculate cost basis can make a world of difference in your tax outcome. As always, TaxAct® is here to help you out. Our easy-to-use tax software walks you through cost basis reporting during the tax filing process, so you can file confidently and keep more of your investment gains in your pocket.
This article is for informational purposes only and not legal or financial advice.
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