At tax time, there's a pressing question you'll have to answer if you've sold investments in a taxable account during the previous year: What were your capital gains and losses?
You'll either owe capital gains taxes on your profits from selling, be able to take a deduction for your losses, or use your losses to offset gains and reduce the tax that's due. However, calculating what you've gained or lost can be more complicated than you might think.
What is cost basis?
Before you determine your profit or loss, you need to know your
original cost basis.
Your profit or loss depends on the difference between your cost
basis and the price at which you sold your investment. In the normal scheme
of things, your cost basis is your original purchase price, but sometimes
you can make adjustments to that figure to make it larger. Other times,
you need to do a little calculating or even some sleuthing to figure out
the correct basis to use.
For instance, calculating basis may be more complicated if you've been buying shares in an individual stock or a mutual fund at different prices over time, such as through a dividend reinvestment program (DRIP).
Calculating basis can also be complicated if your stock has split.
Your basis may also be affected if the company or fund you've invested in has merged with another. And the rules are different if you're not the person who originally bought the investment — for example, if you received it as a gift, in a settlement, or as part of an inheritance.
You don’t have to keep track of the cost basis of investments you make in tax-deferred or tax-exempt accounts, including retirement savings plans and IRAs. That’s because when you withdraw from those accounts you pay tax on all your earnings and on any tax-deductible contributions at your regular rate. The gains or losses since you purchased the investment aren’t part of the calculation.
Common errors
If you're confused about cost basis, you're not alone. The Government Accountability Office (GAO) estimates that 38% of taxpayers reported capital gains incorrectly on their 2001 tax returns. Half of those returns used the wrong cost basis.
