Cost Basis. What Exactly Is It?

By Hightower Westchester on July 1, 2022

Anytime one purchases a capital asset (think securities, real estate, cars, collectibles, etc.), there is a purchase price also known as your cost basis. Your cost basis should be tracked and maintained because at the time of sale, it will have a direct impact on the taxes you may owe.

Let’s start with a purchase of a stock. On March 10^th, you bought 100 shares of ABC company for $10,000 or $100 per share. Your basis will continue to be $100 per share for as long as you own it. There is one thing that can occur to change that and it’s a stock split. In this example let’s assume that ABC company declares a stock split on March 17^th, one week after your purchase and it’s a two-for-one split. And the split will be effective one-week later, on March 24^th. Your total cost basis of $10,000 is still the same but on the day of the split you will receive 100 additional shares, but the price of the stock (let’s assume its still $100) will now be $50 per share. Your basis has now been adjusted to $50 per share but that is now based on owning 200 shares.

Fast forward 13 months – to April 10^th, of the following year. The stock is now at $60 per share, and you decide to sell your full position of 200 shares. Your proceeds will be $12,000. You now have a $2,000 capital gain which will be reported to you and the IRS on form 1099 in March of the following year. Years ago, each person was largely responsible for tracking their own cost basis for everything they bought and sold. Now all of this is done by the custodian, such as Fidelity, who tracks your purchase date, price, shares and any other pertinent information. They have a responsibility to report to you on the 1099 when a security is sold, providing you with an accurate cost basis and hence profit or loss information.

Now let me change the scenario a bit. Let’s say you inherit stock from a long-lost uncle. He leaves you stock in XYZ company worth $100,000. And your uncle bought the stock in 1962 for $1,000. If you didn’t know any better, you would assume you would have a $99,000 gain and hence a large tax bill to pay when you go to sell it. However, there is something in the tax code called “step up in basis” and it applies specifically to something you inherit. The basis of XYZ is now stepped up to the date of death of your uncle and now the cost basis is $100,000, and when you go to sell it, assuming the value of the stock did not change, you have no capital gain. Another fact about inherited stock is it is automatically considered a long-term gain, even if you sell it one month after your uncle passes away. Why is this important? Well, because the sale is considered a long-term gain it is taxed at a more favorable rate.

Now let’s talk about property, specifically your home. For many people their primary home is their largest asset, so the capital gain when they sell it after living in it for a long time could be considerable. Let’s use the following example to walk through this. You and your spouse purchased a house in 1995 for $100,000, and today the house is worth $500,000. You might think you will now have a $400,000 capital gain, but there a few things to consider. First, after living in the house for over 25 years, you probably did some work to it, such as remodeled the bathrooms, finished the basement, redid the kitchen, etc. Let’s say over the 27 years you lived in the house you spent $200,000 on fixed improvements, defined as things that get left behind, so furniture does not count. Your cost basis in the house is now $300,000 ($100,000 + $200,000) so will have a capital gain of $200,000.

For clarification, if the above home was your primary home, you probably would not owe any capital gains tax for one of the following reasons:

1. If you sell the home above and purchase a new primary residence, let’s assume for $600,000, your tax basis rolls forward into the new home, in effect you get to defer any capital gains taxes until such time as you make a final sale (meaning you sell our home and don’t buy another home), and then the next point would apply.
2. If you sell the above but decide to move into a rental and let’s assume that you never buy a home again, the IRS provides an exclusion under rule 701 –https://www.irs.gov/publications/p523 . Without going into too much detail – everyone has a $250,000 capital gain exclusion ($500,000 for a married couple) on the sale of your primary home. Please see the link for more specifics on the rules surrounding this area. 

Cost basis is certainly not the most interesting topic to touch on, but just about everyone, at one point or another, will be affected by a cost basis so having a basic understanding is always helpful. If you have questions about this or would like to understand this in greater detail, don’t hesitate to reach out.

Peter Lang – Managing Director, Partner – Hightower Westchester

914-825-8631 – plang@hightoweradvisors.com