Cost basis is the original value of an asset for tax purposes — typically what you paid for it, including commissions and fees. When you sell the asset, your taxable gain or loss is calculated as the sale price minus your cost basis.
Calculating initial cost basis: - Purchase price + brokerage commissions + transfer taxes + other acquisition costs.
Adjustments to cost basis: - Stock dividends and splits: Cost basis per share adjusts proportionally. - Return of capital distributions: Reduce cost basis dollar-for-dollar. - Reinvested dividends: Each reinvested dividend creates a new lot at the price paid. - Wash sale: Disallowed loss is added to cost basis of replacement shares.
Cost basis methods for multiple lots:
| Method | Description | |---|---| | FIFO (First In, First Out) | Oldest shares sold first (default for stocks) | | Specific identification | Identify exactly which shares are being sold; most flexible for tax planning | | Average cost | Average cost of all shares; commonly used for mutual funds | | LIFO (Last In, First Out) | Newest shares sold first; not permitted for most securities (but used for commodities) |
Inherited property — stepped-up basis: Assets inherited from a deceased person receive a new cost basis equal to the fair market value at the date of death — all pre-death appreciation is permanently excluded from income tax.
Gifted property: Recipient takes the donor's cost basis (carryover basis) — no step-up for gifts.
> Exam tip: Stepped-up basis is one of the most powerful estate planning strategies — heirs inherit appreciated assets tax-free (the gain is wiped out). Reinvested dividends create new lots — a common source of basis errors.