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| Cost
Basis |
What It Is:
Cost basis refers to the original price of an asset. Cost basis is sometimes
called tax basis.
How It Works/Example:
Let�s assume you purchase 100 shares of XYZ Company stock for $5 per share,
and you pay a $10 commission for the purchase. Your cost basis would be:
(100 x $5) + $10 = $510
Income realized from the asset, including dividends and capital distributions
(even if they are reinvested rather than received in cash) increase the cost
basis. Thus in the above example, if your stock paid a $1-per-share dividend
every year for three years, your basis would increase to:
$510 + (100 x $1 x 3) = $810
Money spent on improvements to an asset (such as certain home improvements) are
added to the asset�s cost basis, and depreciation on the asset is subtracted
from the cost basis.
Why It Matters:
An asset�s cost basis becomes very important when the owner sells the asset.
The difference between the sale price and the cost basis is called a capital
gain (if the sale price is higher than the cost basis) or a capital loss
(if the sale price is lower than the cost basis). Capital gains are generally
only taxable when the investor actually sells the asset. Realized losses can
often offset these gains and thus lower the investor�s potential capital-gains
taxes. The length of time the asset is held, among other things, determines the
tax effect of the gain or loss. Changes in tax rates may also influence an
investor's concern about cost basis.
An asset�s cost basis is usually based on its original purchase price, but
sometimes people inherit assets rather than purchase them. In these cases, the
cost basis of the asset becomes the value of the asset at the time the investor
inherits it (this is called a step-up in the basis).
Often, investors accumulate shares of the same stock at different prices over
time. Because of this, when the investor sells some of the shares, he or she
must identify which shares from the �inventory� were sold in order to
calculate capital gains or losses. In general, investors want to minimize
taxable gains by selling the shares with the highest cost basis first. However,
if the investor cannot identify which shares are which, the IRS requires use of
the first-in-first-out (FIFO) method, meaning that the investor must assume he
or she first sells the shares that are held the longest. These older shares may
not have the highest cost basis of the investor�s inventory of shares, and
thus the method could inflate the investor�s tax bill.
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