I’ve recently posted about capital gains/losses and tax loss harvesting. Both of these topics depend on the underlying concept of cost basis. The cost basis is the original value of the asset, which in most cases is the purchase price plus commission paid to the broker. The cost basis should be adjusted for splits, dividends and capital gains distributions. Adjusting the cost basis is useful for minimizing capital gains and therefore taxes.

**Determining the Cost Basis**

Say I bought 100 shares of Target stock today at $49.80 a share. The transaction would cost $4,980 for the Target shares and $5.00 (rounded up from $4.95 purchased through TradeKing) for a total cost basis of $4,985.

**Cost Basis After a Split**

If the same 100 shares of Target underwent a 2 for 1 stock split, I would now own 200 shares of Target. The total cost basis would still remain at $4,985, however, the cost basis per share is different, which is important to know when you sell the shares. Since the total cost basis is unchanged, you just divide the cost basis by the new total number of shares, which is 200. The cost basis per share is now $24.925, which is down from $49.85.

**Cost Basis After Reinvesting Dividends**

Most larger cap stocks pay dividends out to shareholders. Say the 100 shares of Target stock produced a dividend of $200, which was reinvested at $50.00 a share. The total cost basis is now $4,985 plus the reinvested dividend value of $200, which amounts to $5,185. The cost basis per share is now $5,185/104 or $49.86.

**Cost Basis After Capital Gains Distributions**

Mutual funds often provide part of the return on investment in the form of capital gains distributions. These capital gains distributions are often reinvested in the fund. The cost basis for capital gains distributions is calculated in the same way as dividends. The cost basis is equal to the original cost basis plus any reinvested dividends plus and reinvested capital gains distributions.

**Methods for Determining Cost Basis Upon Sale of Shares**

In the above examples the cost basis was determined by adding the original cost basis with dividends and capital gains distributions and determining what essentially is an average cost basis per share. There are other methods for determining the costs basis when selling shares of securities.

- Average Cost Basis – As discussed above it is obtained by taking the total investments made and dividing it by the total number of shares held.
- First In, First Out (FIFO) – FIFO dictates that the first share purchased is the first share sold. The cost basis is maintained for each share from the purchase to the sale.
- Average Cost Double Category Basis – This method requires the shares to be split into two categories: short-term and long-term. A cost basis is determined for each category and shares from either category may be sold depending on the most favorable tax situation.

**Step-Up In Basis**

I received shares of Target stock from my Grandparents when I graduated high school. The cost basis for these shares is determined to be the market value of the asset at the time of inheritance. This step-up in basis is significant when calculating capital gains because the market value at the time of inheritance is almost always greater than the market value at the time of purchase.

**Conclusion**

Understanding how to calculate cost basis is important for minimizing taxes. A personal example of the benefit is the Target Stock that was probably purchased when Target was selling below $10.00 a share and was gifted to me when it was selling around $38.00 a share. Stepping-up my cost basis from below $10.00 to around $38.00 will significantly lower my capital gains taxes when I decide to sell my shares. Also, adjusting the cost basis when reinvesting dividends and capital gains distributions reduces taxes. In the example above, if the 104 shares of Target stock are sold for $55.00 a share, the capital gains will be calculated to be $535 ($5,720 – $5,185) if the dividend reinvestment is included in the cost basis, instead of $735 ($5,720 – $5,185) if the dividend reinvestment is not included. The $200 in reduced taxes is worth it for me to pay attention to the cost basis.

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