What Is Cost Basis?

Whenever you buy a stock or mutual fund you establish a cost basis in that investment, which is the original purchase price of that asset. Over time, though, that cost basis can change based on a variety of factors. 

This means you should keep good records of each of your investments. Your custodian or brokerage firm can typically track the initial cost basis and its changes over time, but you may have to make adjustments.

For example, some folks may not know that commissions or fees you pay your broker can affect the cost basis. The dollar value of these additional costs can be included in the purchase price of the investment.

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It's important to check whether your brokerage firm or custodial firm adds these fees to the initial cost basis of any investments, including stocks, bonds and exchange-traded funds (ETFs).

Dividends or interest collected from your investment, while counted as income for tax purposes, can also potentially be added to your cost basis. If you reinvest that income to purchase more of the underlying investment, the initial cost basis can be adjusted. This could impact your capital gains taxes once the asset is sold because the cost basis will be adjusted to account for the new shares.

Here is where keeping good records comes into play. Often brokerage firms don't account for these reinvested income trades to adjust the tax cost basis in that investment. This means you should track your records, too, and make sure all the figures align.

How is cost basis calculated?

If you buy and sell the same stock, mutual fund, etc., over time, what is the best way to account for the cost basis of these trades? It turns out there are several methods.

Most brokerage firms and other custodial firms use the average cost method. This means that every time you buy or sell a stock, bond, ETF, etc., they calculate the average price from each transaction.

For example, let's say you initially bought 1,000 shares of a stock and paid $10 per share. Your cost basis is $10,000 (1,000 shares x $10 price paid per share).

The stock also pays a 3.3% dividend, meaning you received $330 in dividends for the year. You decide to reinvest those dividends and buy 30 more shares of the stock, which is now trading at $11 per share.

You now have 1,030 shares. But while the initial cost basis was $10.00 per share for 1,000 shares, the new adjusted cost basis that includes the second tranche is $10.03 ($10,000 + $330/1,030). This is slightly higher than the original $10.00 cost basis.

Now if you later sold 100 shares for $11.10, the proceeds from the sale would be $1,110, but what is your profit?

Simple. You use the adjusted cost basis of $10.03 per share to determine your profit. In other words, you would subtract your adjusted cost basis ($10.03) from the $11.10 per share and multiply that by 100 shares. That works out to be a capital gain of $107. 

While averaging is one of the easiest ways to calculate your cost basis, there are several other methods, though they tend to be a bit more complicated. These include First In, First Out (FIFO),  as well as Last In, First Out (LIFO), which calculate your cost basis based on when you bought the asset. Accountants will recognize that this is similar to keeping track of inventory in a company. 

There are good off-the-shelf software application packages to help you keep track of your investment costs. This is what money management firms do to aid in their record-keeping.

Why should I keep track of my cost basis?

The most important reason to track cost basis is to minimize your capital gains taxes and maximize your capital losses. This will help you pay the least amount of taxes.

But there are other reasons too. For one, it helps monitor your investment performance. This is especially true for day traders and high-net-worth or billionaire investors. 

Here is a good example. Options traders who sell short out-of-the-money puts and calls often allow the contracts to expire worthless. That is part of the strategy. Some brokerage firms may not track these kinds of trades accurately, so it's imperative to keep careful records of your own.

The bottom line is that tracking your cost basis allows you to accurately track the returns on your investments and the tax implications those returns may have.

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