What Is Cost Basis, and Why Is It Important?

To put it simply, cost basis is the total amount invested in a stock or a property, plus any fees or commission involved in the purchase. It’s recorded by using the dollar amount of the investment or the effective price per share paid for the investment. 

The second option is essential when you reinvest dividends and capital gains rather than taking them in cash. Also, a cost basis is used when reporting your assets on your taxes, determining capital losses or gains, and reporting how profitable the investment is to investors. 

Determining cost basis

The cost basis of an asset depends on the assets’ type and how they were acquired in some situations. Here is a breakdown of the most common type of assets and how their cost basis is determined. 

• A business
  The purchase price is divided among all the capital assets and assigns a cost basis to each asset. In addition, the value of an individual’s partner interests in a partnership is also considered a capital asset. 
• Bonds and stocks 
  The purchase value is the initial cost basis that includes any brokerage commissions or fees and reinvested dividends (if any). 
• Gifted assets 
  The cost basis of an asset given for investment is either the donor’s cost basis or the fair market value. 
• Inherited assets 
  The cost basis for an inherited asset is the fair market value on the day the former owner died.
• Intangible assets
  The cost basis for intellectual properties like copyrights, patents, franchises, trade names, and trademarks is the cost of acquiring or creating those assets. In an acquisition, the cost basis of goodwill is the difference between the amount paid for the investment and the value of the company acquired. 

Calculating cost basis

How a business estimates the cost basis for capital assets can be reasonably complex since various factors apply to different capital investments. However, they all start with the initial purchase and any other cost of acquiring the investment. 

The purchase cost includes cash and any amount paid in real estate, services, or obligations. For example, the costs of acquiring an investment might include real estate, sales, excise taxes; commissions and fees; installation and testing charges; shipping costs. 

Cost basis calculations might also get more complicated with time, as a cost basis can be adjusted by adding or subtracting different factors. For example, bonds and stocks add the reinvested dividend to the cost basis. 

For real estate, depreciation and capital improvement are added while depreciation is subtracted from the cost basis. Thus, a factory’s cost basis can include the direct cost of construction, minus depreciation, plus the main refit five years later, but not the wages of workers in all those years. 

Examples of cost basis

Most stock transactions are simple. The cost basis is the price and any fees or commissions with no adjustment. In some special situations, however, like stock splits and bankruptcies, mergers, the cost basis is affected by factors beyond the businesses’ control. 

Mergers

If you own stocks in a company that merges with another, you will receive payment in cash, stock, or a combination of cash and stock. With stock payment, the merging company must determine the market value and number of shares, requiring adjustments to the initial cost basis. An all-cash merger is similar to selling all shares. 

Loss or gain is calculated using the original cost basis. In a cash-to-book settlement, any percentage of shares resulting from the exchange ratio causes a cash payment for that fraction. 

Stock splits

The total investments don’t change when the stock splits. The cost of basis is divided amongst the available shares. For instance, in a 2- for- 1 split, the cost basis of every share is divided into half. 

Bankruptcies 

If a business claims Chapter Seven bankruptcy, the value of its shares will depreciate. A loss cannot be reclaimed until the stock is sold or is declared to be valueless. In Chapter Eleven, the shares might continue to be traded, and based on the settlement, the cost basis might remain unchanged. 

Why is cost basis important?

Tracking the cost basis is essential for several reasons. Here is why you are expected to record the cost basis carefully: 

• Understand how an investment has been performing. 

Know whether your investment has been generating losses or profits. If an investment has been making losses, it is time to reevaluate the strategy and redirect your investments.

• Determine the tax rate on a long-term investment.

A long-term investment, one you hold longer than a year, has a lower tax rate than an ordinary income, and the tax rate is based on your general income level. 

• Measure the tax rate on a short-term capital gain. 

A short-term capital gain or money made on your investment might have a tax rate as high as an average income rate.