June 24

Cost Basis in Simple Terms: How to Understand It Correctly

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If you’re interested in anything finance-related, you’ve probably come across the term “cost basis” a couple of times already. To put it simply, the term cost basis refers to the initial value of an asset for tax reasons. This is usually adjusted for return or capital distributions, stock splits, and dividends. There are different ways this term can be used, one of which is to know how much your capital gain is, which is equivalent to the difference between the current market value and your asset’s cost basis.

Other than that, cost basis can also be used to talk about what makes the futures price of a commodity different from the cash price.

Understanding What Cost Basis Actually Means

When you think of the cost basis of an investment, this refers to the initial amount that you invested in, along with any fees or commissions that come with the purchase. There are two ways you can describe this: in terms of dollar amount or the effective per-share price. Cost basis is also known as tax basis, and this is a necessity, especially if you’ve decided to reinvest capital gains and dividends rather than cashing out your earnings.

By reinvesting your distributions, you end up increasing your investment’s tax basis. Now, you need to account for this if you want to pay less tax by reporting a lower capital gain. If you choose not to use a higher tax basis, you potentially pay more on the reinvested distributions. If you plan on selling any of your stock, the first step you need to take if you want to calculate your gains and losses is to determine the right cost basis.

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Some Examples

This section will list down some examples for you to better understand cost basis and how it works. So, let’s say that you bought 100 shares of stock worth $1,000. If the first year of dividends costs $100 while the second year reaches $200 and you decide to reinvest, the earnings you receive from the reinvestment becomes your income according to applicable tax law.

For the purposes of calculation, the adjusted cost basis for this situation would be $1,300 when the stock is sold and not $1,000, which was the initial price. If the sale price is at $1,500, however, the taxable gain would then be $200 and not $500. If the cost basis isn’t recorded correctly and the data entered states $1,000, you’d end up with higher tax liability.

Comparisons

To fully understand the concept of cost basis, you must also consider cost basis comparisons. For example, imagine that you’re an investor who bought the following purchases in a taxable account: 1,250 shares at $8, 1,000 shares at $10, and 1,500 shares at $20. If you want to calculate the average cost basis, divide $50,000 by 3,750 shares. By doing this computation, this means the average cost basis for the fund purchases is $13.33.

Now, what if you plan on selling 1,000 shares for $19? You would then have a capital gain of $5,670 based on the method we showed above.

Conclusion

So, what’s the bottom line here? As you can see, understanding what cost basis is is important, especially for all the investors out there. Not only can it help when they’re creating a tax report, but it could also come in handy when they’re in the process of managing a portfolio. The concept may seem daunting at first, but with a little time and extra effort, you’ll definitely get the hang of cost basis in no time.


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cost basis, finance, investment


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