Cost Basis - Tracking Your Tax Basis

It's not very sexy, but "basis" is one of the most important words in the lexicon of taxes. Sometimes you see it by itself. Sometimes it's called "cost basis" or "adjusted basis" or "tax basis." Whatever. Your basis is essentially your investment in an asset—the amount you will compare to the sale's proceeds to determine your profit or loss when you sell. The higher your basis, the less gain there is to be taxed… and therefore the lower your tax bill. You can see why it's so important to accurately track the basis of any investment you own.

Although this sounds like a simple concept, it isn't necessarily so. For one thing, your basis depends on how you get the property in the first place.

Purchase

The tax basis of stock you purchase is what you pay for it, plus the commission you pay. Say you buy 100 shares of XYZ Inc. at $40 a share, and you pay a $100 commission. The total cost is $4,100, and the tax basis of each of your shares is $41. If you sell the 100 shares for same $40 each, and pay $100 commission on the sale, you have a $200 loss—your $4,100 basis minus the $3,900 proceeds of the sale.

Gift

The basis of securities you receive as a gift depends on whether your ultimate sale of the stock produces a profit or loss. If you sell for a profit, your basis is the same as the basis of the previous owner. In other words, the basis is transferred along with the property. If you sell for a loss, though, the basis is either the previous owner's basis or the value of the stock at the time of the gift, whichever is lower. In other words, you don't get to write off a loss that occurred while the donor owned the securities. Tip: If you get stock or other assets as a gift, ask your benefactor for his or her basis… and keep it with your records.

Inheritance

When you inherit stock or other property, your basis is usually the value of the asset on the date of death of the previous owner. Assuming the asset had appreciated, the basis is "stepped up" to market value, so the income tax on any profit that built up while the previous owner was alive is forgiven. You are responsible only for the tax on appreciation after you inherit the stock. If the stock price falls before you sell it, you can claim a tax loss. If the stock had lost value while owned by your benefactor, your basis is "stepped down" to date of death value.

(An exception to the general rule, which applies only when an estate is large enough for a federal estate tax return to be filed, can set the basis of inherited property at its value six months after the owner died, or when it was sold if during that six month period. If the executor of the estate chooses that value for estate-tax purposes, it becomes your basis in the stock.)

If you own stock or other assets with a spouse as joint tenants or tenants by the entirety—forms of ownership that insure that on the death of one co-owner the survivor becomes the sole owner—the basis is adjusted upward on the death of the co-owner. Basically, the survivor is treated as though he or she inherited half of each share of stock, with its basis increased to current market value.

In a community-property state, the entire basis of community property—not just half—may be increased to date-of-death value upon the death of one spouse. Since that could have a major impact on the taxes due when the stock is sold, check this point carefully if you live in one of these states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin.

When unmarried individuals own property in joint tenancy, each owner's share of the property—and therefore the part of the basis that's stepped up when that owner dies—is determined by contribution to the purchase price. Suppose you and your brother buy a cabin, with you contributing 20% of the cost and him paying the remaining 80%. If he dies first, 80% of the basis would be stepped up. Your basis would become your original investment, plus 80% of the cabin's value at the time of his death.

When a survivor can't prove his or her contribution, the IRS assumes the deceased owner provided all of it. This rule works in the IRS's favor as far as estate taxes are concerned because the full value of the property must be included in the estate of the first joint owner to die. But it backfires for the IRS when it comes to the basis because the entire amount is stepped up.

If you inherit stocks or other assets, be sure to pinpoint the stepped-up basis. How do you set the value? For publicly owned stocks, you should have no problem finding historical prices on the Web. Other kinds of property—such as real estate and antiques—should have been valued at the time the estate was distributed. Ask the executor. If he or she can't help, ask an accountant or attorney experienced with estates for help establishing the proper basis.

When it comes to the holding period for determining whether a sale produces a short- or long-term gain, the sale of inherited property always produces long-term gain or loss, no matter how long you own the property before disposing of it.

Divorce

Thanks to the tax law, in a divorce settlement one piece of property can be worth far more than another with exactly the same market value. The reason is that when property changes hands as a result of a divorce—whether it is the family home, a portfolio of stocks or other assets—the tax basis of the property also changes hands. Because the new owner gets the old owner's basis, he or she is responsible for the tax on all the appreciation before as well as after the transfer.

This rule means you have to look carefully at the tax basis of property that may be part of a settlement. For example, $100,000 worth of stock with a basis of $90,000 is worth significantly more than $100,000 worth of stock with a $50,000 basis. The maximum tax on the sale of the first stock would be $1,500 (15% of the $10,000 gain). The tax on the sale of the second block of stock could be as high as $7,500 (15% of the $50,000 gain).

Stock Splits

When a company in which you own stock declares a stock split, your basis in the shares is spread across both the new and old shares. Say you own 100 shares with a basis of $10 each in a firm that declares a two-for-one split. Your total basis of $1,000 (100 x $10) would be spread among the 200 shares, giving each share a basis of $5.

Dividend-Reinvestment Plans

Your basis in shares purchased through a dividend-reinvestment plan is the stock's cost. Thus, if you have $500 in dividends reinvested and it buys you 30 additional shares, your basis in each share would be $16.67 ($500 divided by 30).

Mutual Funds

Except for money-market funds, in which the value of shares remains constant, the price of mutual-fund shares fluctuates, just like the price of individual stocks and bonds. When you sell shares, you need to know exactly what your tax basis is to pinpoint the taxable gain or loss. Because redemptions can produce short- or long term-results, you also need to track the holding period of all shares you own.

Set up a separate file for each fund you invest in and faithfully keep it up to date. Beyond simplifying your life at tax time, there's a good chance thorough records will save you money.

As with individual stocks, your basis in the shares begins as what you pay for them. If you invest in a no-load fund—one free of a sales commission—your basis is the same as the share's net asset value on the day you buy. If you buy into a load fund, your basis includes the load charge.

A Funny Thing About Mutual Fund Basis

Three brothers, Tom, Dick and Harry, each become the proud owner of 100 shares of FastGrow mutual fund on the same day when the price per share is $25. However, each of them has a different basis. How is this possible?

Tom bought his shares through an advisor who got the shares for him without the regular 5% load (or commission). So, he paid exactly $2,500 for his 100 shares and his tax basis for each share is $25.

Dick is a do-it-yourselfer who doesn't have an advisor managing his money. That means he had to pay the 5% load, so his 100 shares of FastGrow cost him $2,625. That means his tax basis for each share is $26.25.

Harry got his 100 shares as a gift from a doting Uncle who purchased them years ago for $10 a share. That makes Harry's tax basis $10 per share and means he'll have a much bigger tax bill when he sells than either of his brothers.

No wonder you need to keep a running tally of your investment in the fund, from your first acquisition of shares to your final disposal of your last holding. If you liquidate your entire investment at once, your gain or loss will be determined by comparing how much you get with how much you paid for every share you own, whether purchased outright or via dividend reinvestment. By keeping track of all those dividend reinvestments, you'll be sure not to pay more tax than you owe.

If you sell only some of your shares, your record keeping can pay off handsomely. In choosing which shares to sell, you can pick the ones with the basis and holding period combination that produces the best tax result. Assuming all your shares have appreciated and you've owned all of them for over 12 months, if you sell those with the highest basis, you will wind up with the lowest taxable gain. If other investments have produced capital losses, however, you may want to sell low-basis shares to take a bigger profit for the losses to offset.

Since your shares are pooled in a single account by the mutual fund, who knows which shares are sold and which retained? You do, if you keep good records. If you direct the fund to sell specific shares—such as the 100 shares purchased July 3, 1997, for $27.85 a share—it's the basis of those shares that determines the tax consequences of the sale. You should keep records of your sale order, including a copy of the letter to the fund identifying the shares to be sold by the date you acquired them and the price paid. You should also ask the fund for a letter confirming your specific directive, and keep that letter in your files, too. If you order the sale online, you'll probably get an online confirmation. Keep it with your tax records.

If you simply call or write the fund or order the sale online and ask that a certain number of shares be redeemed without specifying which ones, however, it is assumed that the first shares sold are the first ones you bought. This rule is often referred to as FIFO, for "first in, first out."

The IRS does permit mutual fund investors to use an "average" basis for figuring gain or loss on the sale of fund shares. (This method is not available for stocks.) There are really two average basis methods—single- and double-category. This discussion focuses on the single-category method, which is the easier and most used. The double-category method, which involves dividing shares according to how long they have been owned, is almost always more trouble than it's worth.

With the single-category method, you add up your total investment in the fund (including all those bits and pieces of reinvested dividends), divide it by the number of shares you own and, voila, you know the average basis. That's the figure you use to calculate gain or loss on sale. If your investments over the years result in a $22.48 average basis and you redeem 100 shares at $25 a share, for example, you'd have a $252 gain ($2,500 minus $2,248). When it comes to determining whether a gain or loss is long- or short-term, you assume the shares sold are those you've owned the longest.

The single-category method is gaining more and more converts because an increasing number of funds are actually doing the work for shareholders. The funds send out an extra statement each year—a copy of which does not go to the IRS—showing the average basis of shares redeemed during the year. Congress may pass a law requiring all funds to do so.

You can switch between specific identification and FIFO whenever you wish, but once you use the average basis method for a fund, you're stuck with it for as long as you own shares in that fund. IRS Publication 564, Mutual Fund Distributions explains the average basis method in more detail.

Shares Purchased Through Dividend Reinvestment

One area that's easy to overlook when figuring your basis—particularly if you sell all your shares in a fund at once—is shares that you've acquired through automatic reinvestment.

When you purchase shares using reinvested dividends, it's as if the dividends were paid to you in cash, and then you immediately used that cash to purchase new shares.

The amount of the distribution that you use to purchase each full or fractional share is the original cost basis for that share.

Adjusted Basis

Finally, you may need to adjust the basis of your mutual fund shares in certain circumstances.

• Undistributed capital gains. If your mutual fund sends you a Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains, increase your basis by 65% of the undistributed capital gain that you included in income.
• Return of capital (nontaxable) distributions. Reduce your basis (but not below zero) by the amount of any "return of capital" (nontaxable) distributions that you receive from the mutual fund. These kinds of distributions are shown in Box 3 of Form 1099-DIV. They are not the same as capital gain distributions or exempt-interest dividends.

Updated for tax year 2007