Understanding Cost Basis

When you sell a stock and the tax man comes a-knockin', you'll need to spend some time calculating cost basis. Even if you hire an accountant, you should have an understanding of the subject so that you can answer any questions he or he or she has while toiling over this task.

Cost basis is a pretty simple concept. Your cost basis is the amount of money you spend on a stock-including commissions and fees. Kind of like when you buy a new car. The cost of the car is one thing, but if you add in all the additional fees the dealer charges plus tax, tag and title, you get the real cost or, the cost basis.

When calculating cost basis, there are several different factors you need to consider. Let's say you buy 100 shares of XYZ stock for $5.00 a share with a $60 commission. Your cost basis is $5.60. In order to make a profit, you have to sell the stock for at least $5.61, right? No...because you are going to have to pay commission to sell your stock too. If you pay a $60 commission to sell, you'll need to sell your stock for at least $6.21 per share ($500 plus $120 total commissions divided by 100 shares).

If you buy more shares of XYZ at a later date, for a different price, you can effectively raise or lower your cost basis. For instance, if you buy another 100 shares of XYZ at $2.50 per share (again, $60 commission) your cost basis for that lot is $3.10. Your cost basis for the entire 200 shares drops to $4.35 and, considering commissions to sell (just one $60 commission to sell the 200 shares), you must sell for at least $4.66.

If you are reinvesting your dividends, that is going to change your cost basis as well. Let's say you get a $30 dividend and that is invested into XYZ at $3 per share with no fees. You've just purchased 10 shares for $30. You now hold 230 shares, between commissions for the purchase of the first two lots and the cost of all 230 shares, your cost basis is $3.91. Figure in the $60 commission to sell it all for at last $4.19 a share. This is why dollar cost averaging can be such a powerful strategy. You keep buying an taking advantage of little dips in the price and that helps to keep your overall cost basis lower.

Because you pay taxes or claim losses based on your cost basis, it is important to keep all the buy confirmations your brokerage firm sends to you. Don't expect them to have everything on record in perpetuity. Often, your brokerage firm will have your cost basis on your statements which will completely remove the need for your accountant to spend time calculating your cost basis. Sometimes, when mergers happen or systems change, they may lose the information. If you transfer to another firm, your cost basis may not go with your other records. If your brokerage firm folds, you'll have no one to turn to.