Cost Basis

Business, Legal & Accounting Glossary

Definition: Cost Basis




What is the dictionary definition of Cost Basis?

Dictionary Definition


Cost basis reflects the true cost of purchasing a financial asset held over an extended period of time. The longer a stock or other asset is held, the higher the probability that the original purchase price will need to be revised in order to reflect adjustments such as future purchases, stock splits, and dividend payments. For assets purchased in several transactions, the initial cost basis is the average cost from all transactions. If a stock splits, the original cost basis is adjusted downwards. For example, in a two-for-one split, the new cost basis is the old cost basis divided by two. A reverse stock split, where the number of shares outstanding is decreased, will also increase the cost basis. Cost basis can also increase if a dividend is reinvested. In this case, the cost basis goes up to reflect the increased investment. Using an incorrect cost basis can have significant tax implications as it affects the calculation of taxable profits.


Full Definition of Cost Basis


Basis (or cost basis), as used in United States tax law, is the original cost of property adjusted for factors such as depreciation. When property is sold, the difference between the sale price and basis is the income or loss reported at that time on U.S. tax returns. Basis is most commonly used in the computation of capital gains.

From Publication 551: “Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty losses. Also, use it to figure gain or loss on the sale or other disposition of property.”

Determining Basis

For federal income taxation purposes, determining basis depends on how the asset in question was acquired.

  • Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals the purchase price. See IRC § 1012.
  • Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred basis (also called carryover basis). See IRC § 1015. Put simply, gifted assets retain the donor’s basis. This means that the value of the asset at the time of transfer is irrelevant to computing the donee’s new basis. The general rule does not apply, however, if at the time of transfer the donor’s adjusted basis in the property exceeds its fair market value and the recipient disposes of the property at a loss. In this situation the asset’s basis is its fair market value at the time of transfer. See Treas. Reg. § 1.1015-1(a)(1).
  • Assets acquired by inheritance: Assets acquired by inheritance receive stepped-up basis, meaning the fair market value of the asset at the time of the decedent’s death. See IRC § 1014. This provision shields the appreciation in value of the asset during the life of the decedent from any income taxation whatsoever.
  • Adjusted basis: An asset’s basis can increase or decrease depending on changes that occur throughout its lifetime. For this reason, IRC § 1001(a) provides that computing gain requires determining the amount realized from the sale or disposition of property minus the adjusted basis.
  • Capital improvements (such as adding a deck to your house) increase the asset’s basis while depreciation deductions (statutory deductions that reduce the taxpayer’s taxable income for a given year) diminish the asset’s basis. Another way of viewing adjusted basis is to think of the asset as a saving’s account, with capital improvements representing deposits and depreciation deductions representing withdrawals.

Mutual Fund Basis Methods

For mutual funds, there are 4 basis methods approved by the IRS, detailed in Publication 564:

Cost basis methods:

  • Specific share identification
  • First-in, first-out (FIFO)

Average basis methods:

  • Average cost single category (ACSC)
  • Average cost double category (ACDC)

Evaluation Of Methods

Specific share identification is the most record and labour-intensive, as one must track all purchases and sales and specify which share was sold on which date. It almost always allows the lowest tax bill, however, as one has discretion on which gains to realize.

FIFO is the default method used if no other is specified, and generally results in the highest tax bill, as it sells oldest (hence generally most appreciated) shares first.

Average cost single category is widely used by mutual funds, as it is the simplest in terms of record-keeping (only total basis need be tracked) and sale (no specifying required), and results in moderate tax.

 


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Definition Sources


Definitions for Cost Basis are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 19th April, 2020 | 4 Views.