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Understanding Cost Basis

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Written By
Dan Buckley
Contributor Image
Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.
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Updated
Sep 6, 2022

What Is Cost Basis?

Your cost basis is the original value of an asset for tax purposes. When you sell an asset, your capital gain or loss is calculated by subtracting your cost basis from the proceeds of the sale.

If you have held the asset for more than one year, you may be eligible for a lower tax rate on long-term capital gains.

Cost basis isn’t always straightforward to calculate, especially for assets that have been bought and sold multiple times, or that have appreciated in value over time.

The IRS has specific rules for calculating cost basis, which take into account factors like commissions, fees, and reinvested dividends.

It’s important to keep track of your cost basis, because it can have a significant impact on your taxes. Fortunately, most brokers do this for you and you will not have to manually calculate your cost basis.

 

Cost Basis of Futures Contracts

For futures contracts, the cost basis is the difference between a commodity’s spot price and its futures price.

For example, if you’re trading oil and the spot price is $90 and the price of the futures contract is $80, there’s a minus-$10 cost basis.

If it was a different situation, such as trading gold and the spot price is $2,000 and the futures contract is priced at $2,010, there’s a +$10 cost basis.

 

How Stock Splits Affect Cost Basis

A stock split is when a company divides its existing shares into multiple new shares to boost liquidity. This has the effect of reducing the share price by the same proportion.

For example, if you own 100 shares of Company XYZ at $100 per share, and the company does a 2-for-1 stock split, you will end up with 200 shares worth $50 each.

The cost basis of your investment will also be cut in half to $50.

However, in isolation, it doesn’t have the effect of changing the value of your investment or have tax implications.

 

Cost Basis of Gifted or Inherited Shares

If you are gifted shares or inherit shares, then your cost basis is that of the original holder of the shares.

 

What Is Stepped-Up Cost Basis?

If you’ve inherited property, the cost basis for tax purposes is generally “stepped up” to the fair market value (FMV) at the date of the owner’s death. This means that your cost basis in the property is equal to its FMV on the date of the owner’s death.

As a result, any future appreciation in the value of the property will be taxed as a capital gain when you sell it, rather than as ordinary income.

There are some exceptions to this general rule. For example, if the deceased owner had previously gifted the property to you, your cost basis will be “stepped down” to the FMV at the time of the gift.

 

Step-Up in Basis Explained: What is Stepped-Up Cost Basis?