What is Cost Basis

Although understanding the cost basis is fairly basic, it can get complicated for active traders. Fortunately, virtually any security that’s been purchased since 2014 is subject to The Emerging Economic Stabilization Act of 2008. This means that investors who sell a security will receive a 1099-B after the first of the year. This will show the cost basis for any security that investors sold during the year.

In this article we’ll take a deep dive into the concept of cost basis and the different methods used to determine cost basis. We’ll explain how cost basis is different from tax basis. And we’ve included a separate section for cryptocurrency investors to understand their cost basis in different scenarios.

What is Cost Basis?

In its simplest form, cost basis is the original purchase price of any security that an investor has purchased plus any commissions or fees associated with the purchase. For example, if an investor pays $1,000 for shares at $20 and doesn’t pay any commissions, the cost basis of that transaction is $20. Cost basis can also be described in terms of effective price per share. This is frequently used when investors contribute regularly to a mutual fund.

Cost basis is adjusted for events such as stock splits, dividend distributions, and return of capital distributions. The cost basis is needed to calculate the capital gain or loss which is equal to the difference between the asset’s cost basis and the security’s current market value.

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If an individual receives shares as a gift the cost basis will be the same as the original holder who gifted the shares. However, if the shares trade at a lower price than when the shares were gifted, the lower rate is the cost basis.

If an individual receives the shares as part of an inheritance, the cost basis is the market price of the shares on the date of the original owner’s death.

Methods of Determining Cost Basis

In many cases, investors purchase a security more than once a year. A good example of this is regular contributions to mutual funds or exchange-traded funds (ETFs). Of course, the purchase price will be different for every transaction. In this case, brokerage firms will typically use an average cost basis method. As the name implies this method averages the cost basis for each individual transaction.

Investors can also choose to use other methods of determining cost basis including (but not limited to):

• First In First Out (FIFO)
• Last In First Out (LIFO)
• High Cost
• Low Cost

Here’s an example to illustrate the potential benefits of each method:

An investor makes three separate fund purchases:

• Transaction #1 - 1,200 at $20 = $24,000
• Transaction #2 - 1,000 shares at $15 = $15,000
• Transaction #3 - 1,100 shares at $10 = $11,000

Using average cost basis the formula is:

(24,000 + $15,000 + $11,000)/3,300 shares = $15.15

If the investor sells 1,000 shares at $18 the investor would have a capital gain of $2,850. This was determined by the following formula:

($18 - $15.15) x 1000

• If they use the FIFO method the formula would be ($18 - $20) x 1000 = -$2,000
• If they use the LIFO method, the formula would be ($18 - $10) x 1000 = $8,000
• If they use the High-Cost method, the formula would be the same as the FIFO method: ($18 - $20) x 1000 = -$2,000
• If they use the Low-Cost method, the formula would be the same as the LIFO method: ($18 - $10) x 1000 = $8,000

Therefore, an investor may choose to use either the FIFO or High-Cost method as a way of paying no taxes on a loss of $2,000. And they certainly wouldn’t want to choose the LIFO or Low-Cost method as their capital gain would be $8,000.

However, once investors determine a cost basis method for a specific fund or security it must remain in effect. And as noted in the introduction, brokerage firms will provide appropriate annual tax documentation on mutual fund sales based on the cost basis method they chose to use.

Dividends

If dividends are reinvested, tax law stipulates that the reinvested dividends are considered income. Here’s an example:

An investor buys 100 shares of stock for $1,000. In the first year of holding the investment, they receive $100 in dividends. The next year they received $200 in dividends. The adjusted cost basis would now be $1,300. This could be significant when the security is sold because it can lower the capital gain. For example, if the investor sells those 100 shares for $1,600, the taxable gain would be $300 ($1,600-$1,300) as opposed to $600.

Stock Splits

A stock split affects your cost basis per share, but not the actual value of the original investment. For example if you own 1,000 shares and there is a 2:1 stock split you know own 2,000 shares but at one-half the share price before the split.

In this case, you take the original investment amount then divide by the 2,000 shares to calculate the new per share cost basis.

How to Determine Cost Basis for Futures Contracts

For investors who are trading commodities, the cost basis is the difference between a commodity’s local spot price (i.e. the prevailing price for the underlying asset) and its associated futures price (the price that would be given at a specified time in the future). This means the cost basis can be positive or negative depending on the prices involved, particularly since commodity prices tend to be extremely volatile.

Cost Basis and Cryptocurrencies

Cryptocurrencies are a relatively new kind of security and it’s worth noting that, for tax purposes, cryptocurrency is treated as property (not as currency). Therefore, crypto sales made during a calendar year are subject to capital gains taxes. So for crypto assets, the cost basis is the purchase price plus any additional costs such as transaction fees and brokerage commissions. The formula for cash to cryptocurrency transactions is:

(Purchase price of crypto + other fees)/Quantity of holding = Cost Basis

Let’s use an example provided by zenledger.io:

If you invested $150 into Bitcoin in 2021, for $6,537 with a 1.49% transaction fee, your cost basis would be your total purchase price of $152.24 ($150 + 1.49%*150) divided by 0.023 ($150/$6,537) — or $6,619 per BTC.

What about crypto-to-crypto transactions? In this case the formula is similar but with an extra step involved. For example if an investor were to trade $5,000 in Bitcoin for the equivalent value of Cardano. The cost basis for Cardano would be the fair market of the Bitcoin at the time of the sale plus any fees.

Beware of Airdrops & Forks

The cost basis of an airdrop or fork is zero (you didn’t pay anything to acquire the additional cryptocurrency). However, at this time, these events create an immediate tax obligation for the current tax year. That means you owe tax on the cost basis of the newly acquired cryptocurrency in the current tax year.

Using Multiple Wallets & Crypto Exchanges May Present a Problem

Many exchanges, such as Coinbase will prepare cost basis reports if possible. However, there are many circumstances in which the cost basis figures may not be accurate. These include:

• Buying or selling digital assets from elsewhere
• Sending or receiving digital assets from elsewhere
• Stored digital assets on an external device
• Participated in an initial coin offering (ICO)
• Using different accounting methods than the exchange

If this is the case, the investor is still responsible for merging transactions from all of their exchanges and wallets into a single data set to determine cost basis. Here’s a three-step process that can be used:

• Aggregate transactions from every exchange by exporting to CSV or other file formats that can be easily compared
• Merge the transactions and sort them by date to understand when each transaction occurred
• Determine the cost basis for each transaction based on your accounting method

You can imagine that this can become very complicated when investors make hundreds or thousands of crypto transactions in a calendar year. Each of these transactions is a taxable event. To avoid running afoul of the Internal Revenue Service, crypto traders are advised to purchase crypto tax software that can help perform the calculations for these transactions. It’s a fool’s gambit to suggest that transactions done over a blockchain are beyond the reach of the IRS. The blockchain is a distributed public ledger and the IRS will be remarkably efficient at matching a wallet address with a name.

The Bottom Line on Cost Basis

Cost basis is the original value or purchase price of an asset or investment. Knowing the cost basis is essential for tax purposes. The cost basis value is the primary variable used in the calculation of capital gains or losses, which is the difference between the selling price and purchase price.

But more than just for tax purposes, knowing the cost basis of an investment is important for investors to understand if their investors are profitable or not.