If you have ever changed investment brokers in the middle of the tax year, inherited stock or have been gifted property, you understand the amount of work that can go into determining the right cost basis. It takes a lot of effort to figure out the right cost basis due to the complexity of the U.S. tax code.
What Is Cost Basis
Cost basis is generally the original cost of an asset used to calculate capital gains or losses for tax purposes. More often than not, this is the amount in which the asset was purchased for. With that said, an asset is usually a financial instrument such as a share of stock. However in certain circumstances the IRS will ensure that you pay taxes on other types of property, usually received through an estate or as a gift.
In addition to the original cost of an asset, an asset’s cost basis should be adjusted to include transaction costs and reinvested dividends, if relevant to the transaction. So in-order to calculate the capital gains or losses from a simple stock investment just take the cost basis (value of the original investment), add any broker fees and subtract it from the proceeds from the sale of stock. The result will be the capital gains or losses from the sale of the asset.
Cost Basis for Inherited Property
As stated above, there are a variety of cost basis calculations depending on the type of property transfer. When determining the cost basis for inherited property, use the primary valuation amount. This is generally the property’s fair market value at the time of death.
When determining the cost basis for inherited property you can also choose to use an alternative valuation date. This option allows for the valuation of the cost basis of inherited property at its fair market value for up to 6 months after death. Unfortunately, there are a few rules that restrict the election of this valuation method. These are used to prevent the avoidance of tax through increasing the cost basis of the property.
Cost Basis for Gifted Property
Determining the cost basis of gifted property is, in my opinion, the most complicated. This is due to the calculation of the cost basis being contingent on the original cost basis, gift taxes if paid and the fair market value of the property on the date of the gift.
If gifting has occurred and no taxes have been paid, the gift has a dual basis (one basis for a capital gain and another in the case of a capital loss). In the event of a capital gain the donee’s cost basis will be the value of the donor’s original basis. However, if the donee’s transaction results in a capital loss the cost basis will be the lower of the fair market value at the time of gifting or the donor’s original cost basis.
While it would seem that determining the cost basis of property for tax purposes would be an intuitive endeavor, there are a few complicated scenarios you might have to deal with. I feel it necessary to caveat that this article is only an introduction and that tax law changes from time to time. So with that said it’s always a good idea to consult the IRS or a CPA when dealing with complex tax issues.