A Tax-Smart Approach to Your Cost Basis
When it comes to calculating your capital gains tax, understanding your cost basis is crucial. Essentially, the cost basis of an investment is what you paid for it. Working out any capital gains when you sell an investment is just a matter of subtracting your cost basis from your sale price. It sounds simple enough, but calculating your cost basis can be complex—and if you do it incorrectly, you could end up paying the wrong amount in taxes.
Adjusting your cost basis
You can adjust your original purchase price for a variety of reasons. When you buy stocks, for example, you typically calculate your initial cost basis by adding commissions and fees to your per-share purchase price. You can also make adjustments to account for events that affect the per-share price of a stock, such as mergers, stock splits and spinoffs.
Your adjusted cost basis should also reflect reinvested dividends or distributions from mutual funds and exchange-traded funds (ETFs). Why? The IRS treats reinvested dividends as if the money had been distributed directly to you, meaning distributions in a taxable account will be reported on a 1099-DIV form and taxed as regular dividend income. Adjusting your cost basis ensures you won’t also pay capital gains taxes on those funds.
Imagine you invest $10,000 in a stock that pays out $200 in taxable dividends, which you automatically reinvest. That gives you an initial cost basis of $10,000 and an adjusted cost basis of $10,200. Now, imagine the value of your stock rises to $10,500 and you sell your holdings.
Using your original cost basis instead of the adjusted one would result in a bigger capital gain—and therefore a higher tax bill.
Know your accounting method
Another complication arises if you’ve purchased the same security on multiple occasions at a variety of prices.
For example, say you buy 100 shares of a stock for $50 each, and a year later buy 100 more at $60 each. By the following year, the stock is trading at $80 and you sell 50 shares. Your capital gain will differ depending on which shares—those purchased for $50 or $60—you sell.
Let’s look at two common accounting options for such cases.
- First in, first out (FIFO): This is the IRS’s default accounting method. For partial sales, the IRS presumes you’re selling the oldest shares first, which can lead to a larger capital gain if the oldest shares have appreciated more than those acquired later. In the example above, that would mean selling your $50 shares first, resulting in a capital gain of $30 per share, or $1,500 in total.
- Specific identification: This method allows you to identify which shares you’re selling at the time of the sale. It is more flexible than FIFO and gives you the opportunity to optimize results. For our hypothetical portfolio, you could choose to sell the $60 shares first, resulting in a capital gain of $20 per share, or $1,000 in total.
There are other accounting methods out there. Investors may want to discuss their options with a tax professional before selling an investment.
Reporting your cost basis
Your brokerage firm lists the proceeds of sales in your taxable account on Form 1099-B. It may also report your adjusted cost basis, but this will depend on when you bought the asset. Policy reforms introduced after the financial crisis require banks and brokerages to report adjusted cost basis for:
- Stocks bought after 2010
- Mutual funds, ETFs and dividend reinvestment plans bought after 2011
- Other specified securities, including most fixed income securities, acquired after 2013
Whether your cost basis is reported to the IRS or not, you are ultimately responsible for the information on your tax return, so you should save your original purchase and sale documentation. For mutual funds, that includes statements showing automatic reinvestments.
You should also make sure your financial institution is using the accounting method of your choice. If not, you may want to adjust it for future sales.
Using the reporting rules to your advantage
Usually, you want to minimize taxes by recognizing the smallest net gain (or largest loss) possible on your tax return. However, on occasion you might want to do the opposite. For example, you may decide to recognize a larger gain if you can offset it with a current loss or capital-loss carryovers from previous tax years.
Remember, it’s not what you make but what you keep that counts. If you’re tax-smart about calculating and reporting the cost basis of your investments, you may be able to hold on to more of your return. Be sure to check with your tax advisor before entering into any transaction that may have significant tax consequences.
Tracking your cost basis
You can check the cost basis of your Schwab portfolio on schwab.com. Under the Accounts tab, click on “Positions” and then navigate to the Unrealized Gain/Loss tab. The image below shows a hypothetical portfolio:
When you sell a position, you can determine your cost basis by clicking on “Cost Basis Calculator” at the top right in the image above. Here is an example using one of the holdings in a hypothetical portfolio:
The Cost Basis Calculator allows you to look up a stock’s ticker symbol and price. Corporate actions such as name changes, splits and spinoffs going back to 1950 are automatically reflected in a position’s cost basis. You can also include reinvested dividends going back to 1973 and factor in your tax rate.
When you’re ready to calculate, click the Analyze button to receive a report showing realized gains or losses and applicable taxes.
Examples are hypothetical and not representative of any specific investment or situation. Individual stock positions are for illustrative purposes only and are not a recommendation or solicitation to buy or sell. There is no guarantee that positions would have been or may be profitable.
For more information about cost basis reporting, including a schedule of when you can expect to receive your 2014 tax forms from Schwab, log in to schwab.com/OItax.
The information provided is for general informational purposes only. Nothing in this article should be considered as an individualized recommendation or personalized investment or tax advice. The investment and tax strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment or tax strategy for his or her own particular situation before making any decision. Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.