Introduction
If you have sold stocks, inherited assets or had stocks split, you have likely heard the term “cost basis”. Cost basis is one of the most important factors when it comes to calculating your capital gains or losses on investments. It is crucial to understand what cost basis is before making any transactions involving assets. In this article, we will provide a comprehensive guide to understanding cost basis, calculating it accurately and reporting it on your tax returns.
The Complete Guide to Understanding Cost Basis
Cost basis is the original price paid for an asset, including any additional expenses like brokerage fees and commissions. Cost basis also includes adjustments made to the original price like stock splits, stock dividends, and capital distributions. Your capital gain or loss is calculated by subtracting the sale price from the cost basis, and thus having an accurate cost basis is essential to getting your tax calculations right.
Calculating cost basis can vary depending on factors like the type of investment, the length of ownership and more. It is also important to consider the impact of any adjustments made to cost basis. These adjustments are typically due to mergers, stock splits, stock dividends or capital distributions. However, in order to get a clear understanding of how cost basis works, we need to look at some examples of how it is calculated in different situations.
Consider if you bought a stock for $100 and you sold it for $120. In this case, the capital gain would be $20 and the cost basis would be $100. However, if you received a stock dividend worth $5 during the time you held the stock, you would adjust your cost basis from the original $100 to a new cost basis of $105. This would impact your capital gain to $15 instead of $20.
5 Essential Things You Need to Know About Cost Basis
It is important to keep track of the cost basis on assets and investments for several reasons. Firstly, it helps in calculating capital gains or losses on any transactions. Secondly, it helps in reducing any potential tax liabilities by decreasing the amount of taxes payable. Thirdly, it assists in tax planning for future transactions. Here are five essential things you need to know about cost basis:
1. The Effect of Cost Basis on Capital Gain or Loss: To calculate your capital gain or loss on an asset, you need to know the cost basis. You subtract the cost basis from the asset’s sale price, to arrive at the gain or loss realized on that asset.
2. Acquisition and Adjusted Cost Basis: Acquisition cost basis is the original cost paid for the asset, whereas adjusted cost basis reflects any additional costs incurred plus any capital distributions, stock dividends, or stock splits.
3. Keep Track of Cost Basis: The IRS leaves it up to investors to keep track of their own cost basis. Keeping track of this information can minimize any liabilities and help in tax planning.
4. Buy Transactions are Treated Differently from Sell Transactions: When buying shares of a mutual fund, a fractional-share will be purchased and can have an adjusted cost basis. However, when selling that same partial share, you will receive the current market value of that share, which could be higher or lower than the adjusted cost basis.
5. Cost Basis Tracking for Different Investments: The methods for tracking cost basis can vary depending on the type of investment. The most common are stocks, mutual funds and exchange-traded funds (ETFs). It is crucial to understand these differences when calculating cost basis for each type of investment.
Exploring the Different Types of Cost Basis Calculations
There are different methods for calculating cost basis, but the most common are First-In-First-Out (FIFO), Specific Identification, and Average Cost Basis.
In a FIFO calculation, shares that were acquired first are the ones that are sold first. In a Specific Identification calculation, you can stipulate which shares were sold by tailoring an account for that specific sale. Average cost basis involves calculating the total cost of all shares and dividing it by the total number of shares held, which will provide the average price paid per share.
You should consider the different methods available when selling shares in order to potentially minimize taxes payable on the capital gain or loss. The specific identification method, for example, can specify shares that have been held for a long period of time and thus have minimal capital gains potential.
The Importance of Accurately Calculating Your Cost Basis
Accurate cost basis calculations can make a significant impact on tax returns by reducing potential liabilities and ultimately saving the investor money. It is important to avoid common mistakes when calculating cost basis to avoid potential penalties from the IRS. Common mistakes include forgetting to account for any stock dividends, stock splits, or other pro-rata distributions.
Keeping track of cost basis information can be an arduous task, especially for investors who have held several assets for a long period of time. In order to avoid costly mistakes, it may be helpful to consult with an investment advisor to manage the cost basis information. The assistance of a professional can also help in tax planning and reducing liabilities.
How to Report Cost Basis on Your Tax Return
To report cost basis on your tax return, you must use Form 8949 and Schedule D. Form 8949 is used to detail each sale, and Schedule D summarizes these transactions for the tax year. On Form 8949, you must input the date of the sale, the sale price, the cost basis, the adjustment to cost basis, and the capital gain or loss for each transaction.
If you have more than 100 transactions, you must use Form 8949 for the first page and then attach a supporting schedule with all other transactions. It is important to ensure that all the information on the forms is accurate and in accordance with the current tax regulations.
Avoiding Costly Mistakes When Calculating Cost Basis
There are several ways to avoid costly mistakes when calculating cost basis. Firstly, ensure all information is accurately recorded and kept up to date. Secondly, keep track of adjustments made to cost basis due to stock splits or capital distributions. Thirdly, review the tax forms to ensure all information is accurate, and double-check your calculations before filing your taxes.
It’s important to seek professional assistance from an accountant or financial advisor if you’re unsure of how to calculate your cost basis or need assistance in tax planning.
Conclusion
Having an accurate understanding of cost basis is crucial for any investor. This article has provided a complete guide to understanding cost basis, calculating it accurately, and reporting it properly on your tax return. By following this guide, investors can ensure they’re not missing critical information, leading to potential penalties or lost money by not taking their cost basis into account. The key to avoiding these pitfalls is to stay updated on tax regulations and to seek assistance when needed. Keeping this in mind will help you make sound investment decisions and stay in compliance with the IRS.