Here’s a quick run through of what cost basis means and how to use it to calculate the amount of taxes owed on an asset:

  • Many people know the term being used when calculating taxes owed on inherited stocks. It is basically the value of the stock at the time of the original owner’s death. It sets the foundation as the time of death, disregarding the stock’s original value at the time of purchase by the deceased. So if the stock gained or lost since the time of purchase, none of those gains or losses would factor into the calculation. Cost basis resets the clock so that the inheritor doesn’t have to worry about paying taxes on gains or filing for losses while the deceased was alive. This is why it is also called “tax basis”. The rules changed a few times between 2009 and 2012, so navigating through the rules for these years can be confusing. These laws allow exemption of estate taxes up to $5 million, and exemption credit between spouses is allowed, letting the surviving spouse access inheritances without going through the arduous procedure of setting up trusts or other complicated measures in order to access the money. Look up the IRS code or speak with your estate executor for more help.
  • Cost basis is also used when reinvesting dividend and capital gains distributions. When people opt to reinvest earnings instead of receiving it in cash, failure to use a higher cost basis can result in paying taxes twice on the reinvested distributions. When you keep reinvesting these earnings, use the higher cost basis in your calculations so that the difference in the selling price of the stock and the higher cost basis results in the accurate (lower) calculation of your capital gain. (For an illustration, see Investopedia definition online).
  • Be mindful that dividend and capital gains distributions are not the only places where you’ll have to use cost basis calculations. You can add purchase commissions/charges/fees and redemption commissions/charges/fees to your cost basis. When you are merging funds, you’ll have to recalculate the average cost basis per share after the merger. This brings up an important point about cost basis: it is also affected when the number of shares is changed. So in cases like splits and spin-offs, the change in the number of shares will reflect in cost basis calculation.
  • Cost basis is also used in futures trading. It is the difference in the cash price and futures price of a commodity.

When dealing with very old accounts, cost basis records may not always be available. This is when an unknown cost basis calculation can show up. Transferring between one account to another or having transfers take place between accounts belonging to two different social security numbers can also result in unknown cost basis. In this case, there are methods to manually enter in the cost basis while computing taxes.

This little term crosses over many financial instruments, so knowing what it means both generically and specifically can make tax calculations a whole lot easier!

Source by Joseph Quinn