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.
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.
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.
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.
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.
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.
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.
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.
Tracking the cost basis is essential for several reasons. Here is why you are expected to
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.
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.
A short-term capital gain or money made on your investment might have a tax rate as high as an average income rate.