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Opens the scrolled simulated dialogImportant Disclosures

Cost Basis Explained

Why Cost Basis?

When you make investments in a taxable brokerage account, the IRS needs to know your gains (and losses) in order to figure out your tax liability - in other words, the amount of taxes you'll have to pay. Calculating your taxable gain isn't as simple as comparing the share price you paid to the share price you received when you sold. The price you paid for an investment is known as the adjusted cost basis and can be affected by the transactions and costs that occur in your account.

Price vs. Cost

When you view your Portfolio, you may notice that the Cost/Share column doesn't match up to the price you see on your Trade Confirmation. This is because the IRS includes commission costs in your cost basis. Let's look at an example:

You purchase 200 shares of XYZ stock, trading at $12.00 per share. Your total investment costs you $2406.95 once you include the $6.95 commission charge.

  • On your Trade Confirmation, you will see that the price per share was $12.00.
  • In your Portfolio, you'll see that the cost per share is $12.03. To the IRS, you paid $2406.95 for 200 shares of XYZ, for an average cost per share of $12.03.

Why does this matter? When you eventually sell XYZ, the IRS will compare your sale price to $12.03 to determine your taxable gain.

Dividends

Some companies pay out dividends to their shareholders. As a default, your dividend is reinvested to purchase even more of the stock that paid the dividend. Since a dividend reinvestment is technically another purchase, it will affect your entire cost basis.

Using the example above, let's say you purchase 200 shares of XYZ stock, at $12.00. To keep things simple, let's pretend you didn't pay a commission cost on this trade.

  • Your cost basis is $2400 for 200 shares of XYZ, or $12.00 per share.
  • You decide to hold onto your stock for a while, and watch XYZ climb to $16.00 per share.
  • XYZ pays you a $32.00 dividend. When the dividend is reinvested, you get another 2 shares of XYZ - you now own 202 shares of stock.

This is where it may get confusing. You know you purchased XYZ for $2400, and you now own 202 shares of stock. Does that mean your cost per share is $2400/202? Not quite.

You did pay $2400 for your first 200 shares, but your reinvestment counts as another, smaller purchase.

  • Your cost basis is now $2400 + $32, for a total of $2432.
  • You now own 202 shares.
  • Your new cost per share is 12.04. It makes sense that your average cost per share is a bit more than what it used to be, since your newest shares were more expensive.

Wash Sale Deferrals

If you trade frequently in your account, a wash sale deferral could affect your cost basis. Simply put, a wash sale occurs when:

  • You sell shares of a security at a loss
  • Within 30 days (before or after) the sale, you purchase the same security

If both of those things occur, the IRS prevents you from reporting your loss - temporarily. Instead, the loss is deferred and can be reported when you sell your new shares. Let's look at an example:

  • You own 100 shares of XYZ that cost you $12.00 per share
  • Feb 12th - You sell your 100 shares at $10.00 per share - that's a loss of $2.00 per share (or $200 total). Typically, this is where you would report a $200 loss to the IRS.
  • March 1st - You purchase 100 new shares of XYZ at $9.00 per share. This purchase triggers a wash sale deferral - the IRS won't let you report your $2.00 loss.

Instead, the $2.00 is added to your new cost basis. You'll now see that your cost basis is $9.00 per share, plus $2.00 per share, for a total of $11 per share.

That's how the math works, but you may be wondering why your new cost basis has to include the $2.00 per share loss. Let's look at what happens when you sell XYZ for $14.00/sh.

  • If we use the wash sale rule to calculate your gain:
    • Cost Basis: $11.00/sh
    • Proceeds: $14.00/sh
    • Gain: $3.00/sh

If you're concerned about making sure your gain/loss is reported correctly, consider breaking down the transactions that caused a wash sale into the two separate trades:

  • Buy at $12.00 per share, then sell at $10.00 per share on Feb 12th
    • $2.00/sh loss
  • Buy at $9.00 per share on March 1st, then sell at $14.00 per share
    • $5.00/sh gain

You'll see that the total gain is again $3.00/sh. The most important thing to realize about wash sales is that the wash sale deferral is temporary - when you've eventually sold all of your shares, the gain/loss reported to the IRS doesn't change. Of course, you should always check with a tax advisor to make sure you are reporting the correct gain/loss for your investments.