What is Cost Basis?
In simplest terms, cost basis (or “tax cost” or “tax basis”) refers to the price you paid for an asset adjusted upward for reinvested dividends and capital gains and downward for return of capital and capital losses.
What cost basis won’t necessarily tell you is how much money you’ve made or lost on an investment—i.e., you cannot always subtract an investment’s cost basis from its current market value to determine the gain or loss on that investment. Instead, cost basis is only intended for the calculation of capital gains and losses when an asset is sold.
Let’s take a look at an example that demonstrates cost basis and the gain or loss on an investment.
Let’s say you invest $10,000 in Mutual Fund A and $10,000 in Mutual Fund B on January 1, 2016. The $10,000 investment is the original cost basis for each fund.
During 2016, the price of Mutual Fund A goes up to $11 per share, and the fund pays no dividends. So Mutual Fund A ends the year with a balance of $11,000.
Mutual Fund B, on the other hand, experiences no market gains but receives a $1 per share dividend, which is used to reinvest in the fund by purchasing an additional 100 shares at $10 per share. As a result, Mutual Fund B also ends the year with a balance of $11,000.
Note that the Year-end Values for the two investments are the same ($11,000), even though they increased in value by $1,000 during 2016 in two different ways—Mutual Fund A through price appreciation and Mutual Fund B through a dividend distribution and subsequent reinvestment.
However, the cost bases for Mutual Fund A and Mutual Fund B are now different at the end of 2016.
When Mutual Fund A’s price increased to $11 per share, its value increased to $11,000—but the cost basis remained at $10,000 because there were no realized gains and thus no tax implications. On the other hand, when Mutual Fund B’s dividends were reinvested, the cost basis increased to $11,000 because the dividends (taxable income) were used to buy more shares and treated like any other investment made in the fund.
If you were to incorrectly calculate earnings by subtracting each investment’s cost basis from its current market value, you would calculate that Mutual Fund A had a gain of $1,000 and Mutual Fund B had a $0 gain for 2016. In reality, both investments increased in value by $1,000 during 2016—Mutual Fund A through market appreciation and Mutual Fund B through a dividend distribution.
Why It Matters
Cost basis is used for tax reporting and payment purposes and is only important when you sell the asset. The difference between the sale price and the cost basis is called a capital gain (if the sale price is higher than the cost basis) or a capital loss (if the sale price is lower than the cost basis).
In our example above, if you were to sell Mutual Fund A on December 31, 2016, you would owe taxes on the $1,000 capital gain ($11,000 Year-end Value less its $10,000 Year-end Cost Basis) in accordance with your capital gains tax rate.
By contrast, if you were to sell Mutual Fund B on December 31, 2016, there would be no capital gain since the investment’s value is equal to its cost basis. You would owe no taxes on the transaction because you would have paid taxes on the dividend.
We hope this explanation is helpful.