# Understanding Cost Basis: Calculation, Examples, and Tax Impact

## What Is Cost Basis?

When you purchase an asset, its initial value, known as the cost basis, plays a crucial role in determining capital gains taxes down the road. Typically, the cost basis is the purchase price, adjusted for events like [stock splits](https://www.investopedia.com/terms/s/stocksplit.asp), [dividends](https://www.investopedia.com/terms/d/dividend.asp), and [capital](https://www.investopedia.com/terms/r/returnofcapital.asp) distributions.

Understanding your cost basis is essential, as it influences how much profit you report when you sell your asset. Additionally, recognizing how the cost basis can differ, such as in commodities with different cash and futures prices, is vital for accurate tax reporting and strategic financial planning

### Key Takeaways

*   Cost basis refers to the original value of an asset, adjusted for stock splits, dividends, and return of capital distributions, and is critical for determining capital gains tax.
*   Reinvesting dividends increases the cost basis of your investments, which can lower your taxable gain and prevent paying taxes twice on the reinvested amounts.
*   Investors can choose various cost basis methods for calculating gains, such as first in first out (FIFO), last in first out (LIFO), and average cost, which can significantly affect tax liabilities.
*   A stock split affects the per-share cost basis, and gifted or inherited shares have different rules for determining cost basis, impacting the taxable amount upon sale.
*   In real estate, the IRS validates cost basis with purchase documents, while for futures contracts, cost basis is the difference between spot and futures prices, which can be positive or negative.

![Cost Basis](https://www.investopedia.com/thmb/uP32fcrij2hnzykN80bhBriCTzA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/costbasis.asp_final-4be425063ddb41648787429a607f098f.png)

*— Ellen Lindner / Investopedia*

## How Cost Basis Impacts Your Investments  

Essentially, the cost basis of an investment is the original amount invested, plus any purchase-related commissions or fees. This can either be described in terms of the dollar amount of the investment, or the effective per-share price paid for the investment.

Using the correct cost basis, also referred to as the tax basis, is important especially if you reinvested dividends and [capital gains distributions](https://www.investopedia.com/terms/c/capitalgainsdistribution.asp) instead of taking the earnings in cash. Reinvesting distributions increases the tax basis of your investment, which you must account for to report a lower capital gain and therefore pay less tax.

If you don’t use the higher tax basis, you could end up paying taxes twice on the reinvested distributions. Determining the correct cost basis is also the first step when [calculating gains and losses](https://www.investopedia.com/ask/answers/07/calculategains.asp) after a stock is sold.

> **Important**
>
> Reinvesting dividends increases the cost basis of a stock because dividends are used to buy more shares.

The [average cost basis method](https://www.investopedia.com/terms/a/averagecostbasismethod.asp) is commonly used by investors for [mutual fund tax reporting](https://www.investopedia.com/ask/answers/06/mutualfundcostbasis.asp). A cost basis method is reported with the brokerage firm where your assets are held. Many brokerage firms default to the average cost basis method. Investors can also choose from other methods, including first in first out (FIFO), last in first out (LIFO), high cost, low cost, and more.

Once you choose a cost basis method for a mutual fund, it must stay in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their [cost basis method elections](https://www.investopedia.com/articles/mutualfund/cost-basis-mutual-funds.asp).

The concept of cost basis is straightforward but can become complicated. Tracking cost basis is essential for tax purposes and measuring investment success. The key is to keep good records and simplify the investment strategy where possible.

## Example: Calculating Cost Basis  

For example, if you bought 100 shares for $1,000 and reinvested $100 and $200 in dividends over two years, tax law treats these reinvested earnings as income.

For tax calculation purposes, the adjusted cost basis when the stock is sold will be recorded at $1,300 instead of the original [purchase price](https://www.investopedia.com/terms/p/purchaseprice.asp) of $1,000. If you sell for $1,500, your [taxable gain](https://www.investopedia.com/terms/t/taxablegain.asp) is $200 ($1,500 - $1,300) instead of $500 ($1,500 - $1,000). If the cost basis is incorrectly recorded as $1,000, this results in a higher tax liability than would normally be due.

## Comparing Different Cost Basis Methods

Cost basis comparison can be an important consideration. Assume that an investor made the following consecutive fund purchases in a taxable account: 1,500 shares at $20, 1,000 shares at $10, and 1,250 shares at $8. The investor’s average cost basis is calculated by dividing $50,000 by 3,750 shares. The average cost is $13.33.

Suppose the investor then sells 1,000 shares of the fund at $19. The investor would have a [capital gain](https://www.investopedia.com/terms/c/capitalgain.asp) of $5,670 using the average cost basis method.

*   Gain/loss using average cost basis: ($19 - $13.33) × 1,000 shares = $5,670

Results can vary significantly by cost basis.

*   First in first out: ($19 - $20) × 1,000 shares = -$1,000
*   Last in first out: ($19 - $8) × 1,000 shares = $11,000
*   High cost: ($19 - $20) × 1,000 shares = - $1,000
*   Low cost: ($19 - $8) × 1,000 shares = $11,000

In this case, the investor would be better off if they had selected the FIFO method or the high-cost method to determine the cost basis before selling the shares. These methods would result in no tax on a loss of $1,000. With the average cost basis method, the investor must pay a [capital gains tax](https://www.investopedia.com/terms/c/capital_gains_tax.asp) on the gain of $5,670.

## Adjusting Cost Basis After Stock Splits

A stock split changes your cost basis per share but not the overall value of your investment. Continuing with the above example, suppose the company issues a 2:1 stock split where one old share gets you two new shares. You can calculate your cost basis per share in two ways:

*   Take the original investment amount ($10,000) and divide it by the new number of shares you hold (2,000 shares) to arrive at the new per-share cost basis ($10,000 ÷ 2,000 = $5.00).
*   Take your previous cost basis per share ($10) and divide it by the split factor of 2:1 ($10.00 ÷ 2 = $5.00).

## Determining Cost Basis for Gifted and Inherited Stocks

 If shares are a gift, your cost basis is the original holder's cost basis. If the shares are trading at a lower price than when the shares were gifted, the lower rate is the cost basis.

If the shares were given to you as an inheritance, then the cost basis of the shares for you as the inheritor is the current [market price](https://www.investopedia.com/terms/m/market-price.asp) of the shares on the date of the original owner’s death.

Many factors will affect your cost basis and eventually your taxes when you decide to sell. If your true cost basis is unclear, please consult a [financial advisor](https://www.investopedia.com/terms/f/financial-advisor.asp), accountant, or tax lawyer.

## Understanding Cost Basis in Futures Contracts

Regarding futures, the cost basis is the difference between a commodity’s local spot price and its associated futures price. For example, if a particular corn futures contract happens to be trading at $3.50, while the current market price of the [commodity](https://www.investopedia.com/terms/c/commodity.asp) today is $3.10, there is a 40-cent cost basis.

If the reverse were true, with the future contract trading at $3.10 and the spot price being $3.50, the cost basis would be negative 40 cents, as a cost basis can be positive or negative depending on the prices involved.

The local spot price represents the prevailing price for the underlying asset, while the price listed in a futures contract refers to a rate that would be given at a specified point in the future. Futures prices vary from contract to contract depending on the month when they are set to expire.

As with other investments, the spot price changes with market conditions. As the delivery date approaches, the price of futures and the spot price shift closer together.

## What Is the Difference Between Cost Basis and Tax Basis?

Cost basis is the original cost of obtaining an asset. It can include the purchase price and any fees. During the time that an asset is held, its value can change due to changes in market value, as well as any depreciation. The tax basis is the adjusted cost basis of the asset at the time the asset is sold. Capital gains tax will be charged on the difference between the sale price and the cost basis.

## What Is the Importance of Cost Basis?

Cost basis is important because it is how capital gains taxes are charged. If you sell an asset for more than the cost basis, you will incur taxes on the profit. If you sell an asset for less than the cost basis, you will incur a loss and not incur any taxes. This loss can also be used to offset taxes on other capital gains.

## How Does the IRS Verify Cost Basis in Real Estate?

In real estate transactions, the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp) can verify the cost basis by looking at the closing statement of when the property was purchased, or any other legal documents associated with the property, such as tax statements.

## The Bottom Line

The cost basis, usually the purchase price of an asset, is used to determine how much an investor will pay in capital gains. The larger the difference between the cost basis and the sale price (if the asset has appreciated), the larger the tax bill will be monetarily.

If there are a lot of aspects to the cost basis, such as fees, or if the cost basis is adjusted due to dividends or stock splits, or if distributions are reinvested, then determining the capital gain can be complicated. It can be helpful to use a tax advisor in these scenarios.