When you sell securities in a taxable investment account, you have to know your “basis” in the securities to determine whether you have a gain or a loss on the sale — and the amount. Generally, your basis is the price you paid for your shares of stock or a mutual fund, adjusted for any reinvested dividends or capital gain distributions, as well as for any costs of the purchase.
Although the cost basis calculation sounds straightforward enough, there’s more to the story.
Inherited and Gifted Securities
Though basis is usually derived from cost, inheritances are treated differently. Generally, the basis of inherited securities is reset at their date-of-death value.
With gifted securities, the person receiving the securities generally takes the basis of the person who gave them. However, if gift tax was paid, a basis adjustment may be necessary. And, if the securities’ fair market value on the date of the gift is less than their original cost, you use that lower value to determine any loss on a subsequent sale.
Stock Dividends and Splits
Instead of distributing cash dividends, companies sometimes distribute stock dividends. Stock dividends are generally not taxable. However, a basis adjustment needs to be made. If the new stock you receive is identical to the old stock — for example, you receive two new shares of XYZ common stock for each share of XYZ common stock you own — you simply divide the basis of your old stock by the total number of shares held after the distribution to arrive at your new basis for each share.
Stock splits also result in basis adjustments. For example, if a company has a “two-for-one split” of its stock, the original basis must be divided between the two new shares. Conversely, companies sometimes have “reverse splits,” such as when three shares are exchanged for one, in which case the basis in the original three shares is now the basis of the new share.
Keeping track of share basis through a series of mergers, spinoffs, etc., can be very complicated. Often, taxpayers must research the terms of the relevant transactions by contacting the company directly or logging on to the company’s website.
Selling Less Than Your Entire Holding
If you sell less than your entire holding in a particular stock and can adequately identify the shares you sold (“specific identification”), you may use their basis to determine your gain or loss. Adequate identification involves delivering the stock certificates to your broker or, if your broker holds the stock, telling your broker the particular stock to be sold and getting a written confirmation. If you can’t adequately identify the shares you sell, you may use the FIFO —“first in, first out” — method to determine your basis.
With mutual funds, you are also allowed to elect to use the “average basis” method of accounting for shares sold. With this method, the total cost of all the shares owned is divided by the total number of shares owned.
Tax-deferred and Tax-exempt Investments
Cost basis is generally not an issue with securities held in tax-deferred investment accounts, such as individual retirement accounts (IRAs) or employee retirement accounts. With these accounts, you are not taxed on capital gains but will be taxed at ordinary income-tax rates on distributions you receive. (Qualified Roth distributions are an exception.) Also note that though interest on municipal bonds may be tax exempt, any gain realized from selling such bonds is taxable, so it’s important to keep the information you’ll need to determine your basis.
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