Cost basis
It's not very exciting, but "basis" is one of the most important words in the lexicon of taxes. Sometimes you see it by itself. Sometimes it's called "cost basis" or "adjusted basis" or "tax basis." Whatever it's called, it's important to calculating the amount of gain or loss when you sell an asset.
Your basis is essentially your investment in an asset—the amount you will use to determine your profit or loss when you sell it. The higher your basis, the less gain there is to be taxed—and therefore, the lower your tax bill. This is why it's so important to accurately track the basis of any investment you own.
Although this sounds like a simple concept, it isn't necessarily so. For one thing, your basis depends on how you get the property in the first place.
Purchases
The tax basis of stock you purchase is what you pay for it, plus the commission you pay. Say you buy 100 shares of XYZ Inc. at $40 a share, and you pay a $100 commission. The total cost is $4,100 and the tax basis of each of your shares is $41.
If you sell the 100 shares for same $40 each, and pay $100 commission on the sale, you have a $200 loss—your $4,100 basis minus the $3,900 proceeds of the sale.
Gifts
The basis of securities you receive as a gift depends on whether your ultimate sale of the stock produces a profit or loss. If you sell for a profit, your basis is the same as the basis of the previous owner.
In other words, the basis is transferred along with the property. If you sell for a loss, though, the basis is either the previous owner's basis or the value of the stock at the time of the gift, whichever is lower. In other words, you don't get to write off a loss that occurred while the donor owned the securities.
TurboTax Tip:
If you get stock or other assets as a gift, ask your benefactor for information about his or her basis—and keep that information with your records.
Inheritance
When you inherit stock or other property, your basis is usually the value of the asset on the date of death of the previous owner. Assuming the asset had appreciated since the original owner purchased it, the basis is "stepped up" to current market value, so the income tax on any profit that built up while the previous owner was alive is forgiven. You are responsible only for the tax on appreciation after you inherit the stock. If the stock price falls before you sell it, you can claim a tax loss. If the stock had lost value while owned by your benefactor, your basis is "stepped down" to the date of death value.
An exception applies only when an estate is large enough for a federal estate tax return to be filed. The exception can set the basis of inherited property at its value six months after the owner died, or when it was sold if during that six-month period. Using this exception, called the alternate valuation date, may make sense if the value of the estate's assets has fallen during the six months following the owner's death. If the executor of the estate chooses to value assets using the alternate valuation date for estate tax purposes, the value on that date becomes your basis in the inherited stock.
Married couples, joint tenants
If you own stock or other assets with a spouse as joint tenants or tenants by the entirety—forms of ownership often used by married couples that ensure that on the death of one co-owner the survivor becomes the sole owner—the basis of what is transferred to the survivor is adjusted upward on the death of the co-owner. Basically, the survivor is treated as though they inherited half of each share of stock, with its basis increased to the date-of-death value.
In community property states, the basis of the entire community property—not just half—may be increased to date-of-death value upon the death of one spouse. Since that could have a major impact on the taxes due when the stock is sold, check this point carefully if you live in one of these states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington or Wisconsin.
When unmarried individuals own property in joint tenancy, each owner's share of the property—and therefore the part of the basis that's stepped up when that owner dies—is determined by contribution to the purchase price. Suppose you and your brother buy a cabin, with you contributing 20 percent of the cost and him paying the remaining 80 percent. If he dies first, the property passes to you as the joint owner. And 80 percent of the basis would be stepped up. Your basis would become your original investment, plus 80 percent of the cabin's value at the time of his death.
When a survivor can't prove his or her contribution, the IRS generally assumes the deceased owner provided all of it. This rule works in the IRS's favor as far as estate taxes are concerned because the full value of the property must be included in the estate of the first joint owner to die. But it works in the taxpayer's favor when it comes to the basis because the entire amount is stepped up.
Determining stepped-up basis
If you inherit stocks or other assets, be sure to pinpoint the stepped-up basis. How do you set the value? For publicly owned stocks, you should have no problem finding historical prices on the Web. Other kinds of property—such as real estate and antiques—should have been valued at the time the estate was established. Ask the executor. If they can't help, ask an accountant or attorney experienced with estates for help establishing the proper basis.
In regard to the holding period for determining whether a sale of an inherited asset produces a short- or long-term gain, the sale of inherited property always produces long-term gain or loss, no matter how long you own the property before disposing of it.
Special Basis Rules for Assets Inherited from 2010 Decedents
The basis rules for inherited assets explained above apply to assets inherited from individuals who die before or after 2010. A special set of basis rules applies to assets inherited from decedents who died in 2010. Under the special rules, the starting point for basis is the lower of: (1) the asset’s fair market value on the date of death or (2) the decedent’s basis.
For appreciated assets (those with date-of-death fair market value in excess of the decedent’s basis), a limited basis step-up rule can be used at the discretion of the estate’s executor. Under the limited basis step-up rule, the maximum allowable total basis step-up is generally $1.3 million, but a surviving spouse is granted an additional step-up allowance of up to $3 million.
Bottom line: for larger estates of individuals who died in 2010, the limited basis step-up rule can result in lower basis for inherited assets and higher capital gains taxes when those assets are sold. Under the 2010 tax act, executors have the option of using the 2011 rules, which include a step up in basis, for people who died in 2010. So, check with the executor about the basis of property you inherited from someone who died in 2010.
Divorce
Thanks to the tax law, in a divorce settlement one piece of property can be worth far more than another with exactly the same market value. The reason is that when property changes hands as a result of a divorce—whether it is the family home, a portfolio of stocks or other assets—the tax basis of the property also changes hands.
Because the new owner gets the old owner's basis, they are responsible for the tax on all the appreciation before, as well as after, the transfer.
This rule means you have to look carefully at the tax basis of property that may be part of a settlement. For example, $100,000 worth of stock with a basis of $90,000 is worth significantly more than $100,000 worth of stock with a $50,000 basis. Typically, the maximum tax on the sale of the first stock would be $2,000, equaling 20% long-term capital gains tax on the $10,000 gain, assuming the stock had been held for more than one year. The tax on the sale of the second block of stock could be as high as $10,000 (20% of the $50,000 gain), again assuming the stock had been held for more than one year.
Stock splits
When a company in which you own stock declares a stock split, your basis in the shares is spread across the new and old shares. Say you own 100 shares with a basis of $10 each in a firm that declares a two-for-one split. Your total basis of $1,000 (100 x $10) would be spread among the 200 shares, giving each share a basis of $5.
Dividend reinvestment
Your basis in shares purchased through a dividend-reinvestment plan is the stock's cost. Thus, if you have $500 in dividends reinvested and it buys you 30 additional shares, your basis in each share would be $16.67 ($500 divided by 30).
Mutual funds
Except for money market funds, in which the value of shares remains constant, the price of mutual fund shares fluctuates, just like the price of individual stocks and bonds. When you sell shares, you need to know exactly what your tax basis is to pinpoint the taxable gain or loss.
Because redemptions can produce short- or long-term gain results, you also need to track the holding period of all shares you own.
Set up a separate file for each fund you invest in—either on paper or electronically on your computer—and faithfully keep it up to date. Beyond simplifying your life at tax time, there's a good chance thorough records will save you money.
As with individual stocks, your basis in the shares begins as what you pay for them. If you invest in a no-load fund—one free of a sales commission—your basis is the same as the share's net asset value on the day you buy. If you buy into a load fund, your basis includes the load charge.
A funny thing about mutual fund basis
Three brothers, Tom, Dick and Harry, each become the proud owner of 100 shares of FastGrow mutual fund on the same day when the price per share is $25. However, each of them has a different basis. How is this possible?
Tom bought his shares through an advisor who got the shares for him without the regular 5% load (or commission). So he paid exactly $2,500 for his 100 shares and his tax basis for each share is $25.
Dick is a do-it-yourself type who doesn't have an advisor managing his money. That means he had to pay the 5% load, so his 100 shares of FastGrow cost him $2,625. That means his tax basis for each share is $26.25.
Harry got his 100 shares as a gift from a doting Uncle who purchased them years ago for $10 a share. That makes Harry's tax basis $10 per share and means he'll have a much bigger tax bill when he sells than either of his brother.
No wonder you need to keep a running tally of your investment in the fund, from your first acquisition of shares to your final disposal of your last holding. (Although some funds will keep track of it for you.) If you liquidate your entire investment at once, your gain or loss will be determined by comparing how much you get with how much you paid for every share you own, whether purchased outright or via dividend reinvestment. By keeping track of all those dividend reinvestments, you'll be sure not to pay more tax than you owe.
If you sell only some of your shares, your record keeping can pay off handsomely. In choosing which shares to sell, you can pick the ones with the basis and holding period combination that produces the best tax result. Assuming all your shares have appreciated and you've owned all of them for over 12 months, selling those with the highest basis will produce the lowest taxable gain. If other investments have produced capital losses, however, you may want to sell low-basis shares to take a bigger profit for the losses to offset.
Determining what to sell and when
Since the mutual fund keeps your shares in a single account, when you make a sale it’s difficult to know which shares you are selling and which ones you are retaining.
You do, if you keep good records. If you direct the fund to sell specific shares—such as the 100 shares purchased July 3, 1997, for $27.85 a share—it's the basis of those shares that determines the tax consequences of the sale.
You should keep records of your sales order, including a copy of the letter to the fund identifying the shares to be sold, by the date you acquired them and the price paid. You should also ask the fund for a letter confirming your specific directive, and keep that letter in your files, too. If you order the sales online, you'll probably get an online confirmation. Keep it with your tax records.
If you simply call or write the fund, or order the sale online, and simply ask that a certain number of shares be redeemed without specifying which ones, it is assumed that the first shares sold are the first ones you bought, unless you have specified a different ordering. This rule is often referred to as FIFO, for "First In, First Out."
The IRS does permit mutual fund investors to use an "average" basis for figuring gain or loss on the sale of fund shares. (This method is not available for stocks.) There are really two average-basis methods—single- and double-category.
This discussion focuses on the single-category method, which is the easiest and most-used. The double-category method, which involves dividing shares based upon how long they have been owned, is rarely used and almost always more trouble than it's worth.
With the single-category method, you add up your total investment in the fund (including all those bits and pieces of reinvested dividends), divide it by the number of shares you own, and voila, you know the average basis. That's the figure you use to calculate gain or loss on sale. If your investments over the years result in a $22.48 average basis and you redeem 100 shares at $25 a share, for example, you'd have a $252 gain ($2,500 minus $2,248). When it comes to determining whether a gain or loss is long- or short-term, you assume the shares sold are those you've owned the longest.
The single-category method is gaining more and more converts because an increasing number of funds are actually doing the work for shareholders. The funds often send out an extra statement each year—a copy of which currently does not go to the IRS —showing the single-category average basis of shares redeemed during the year.
You can switch between specific identification and FIFO whenever you wish, but once you use one of the average basis methods for a fund, you're stuck with it for as long as you own shares in that fund. IRS Publication 550: Investment Income and Expenses explains the average basis method in more detail.
Shares purchased through dividend reinvestment
One area that's easy to overlook when figuring your basis—particularly if you sell all your shares in a fund at once—is shares that you've acquired through automatic reinvestment.
When you purchase shares using reinvested dividends, it's as if the dividends were paid to you in cash, and then you immediately used that cash to purchase new shares.
The amount of the distribution that you use to purchase each share is the original cost basis for that share.
Adjusted basis
Finally, you may need to adjust the basis of your mutual fund shares in certain circumstances:
- Undistributed capital gains. If your mutual fund sends you a Form 2439: Notice to Shareholder of Undistributed Long-Term Capital Gains increase your basis by the amount of undistributed capital gain that you include in income and reduce your basis by the amount of tax paid by the fund on the undistributed gain (both amounts are reported to you on Form 2439). Finally, don’t forget to claim a tax credit on your Form 1040 for the amount of tax paid by the fund in the tax year.
- Return of capital (nontaxable) distributions. Reduce your basis (but not below zero) by the amount of any "return of capital" (nontaxable) distributions that you receive from the mutual fund. These kinds of distributions are shown in Box 3 of Form 1099-DIV. They are not the same as capital gain distributions or exempt-interest dividends.
Help is on the way
Thanks to a law passed in 2008, taxpayers receive help keeping track of their tax basis. The law requires brokers to track the basis of specified securities (including stocks and mutual fund shares) purchased in 2011 and later years and report the basis amounts to investors (and the IRS) when the securities are sold. Congress didn’t impose this requirement just to be nice; the lawmakers hope that basis reporting will lead to more profit being reported and more taxes being collected. As stated, however, the new basis reporting rules which are phased-in over three years only apply to specified securities that are acquired in 2011 and beyond. Therefore, brokers need not supply basis information for security sales that occurred in 2010 or earlier years.
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