Cost basis is the effective purchase price of a stock to use for tax purposes. In this article we'll understand how it works, its implication on both our gains and taxes, and look at a few ways the cost basis can be determined.

Cost basis is not simply the price we bought the stock for. The cost of trading (the commission or fee we paid to the brokerage for our trade) and any dividends from that stock that we reinvested both alter the cost basis. There are a few more factors that affect the cost basis. In this article we're only focused on understanding the different cost basis techniques — ways cost basis can be calculated.

Why Cost Basis is Important

When selling stocks, the amount of tax we owe depends on two things: the gains we made, and the capital gains tax rate. The former depends on the purchase price and the sale price. The latter depends on how long we held the stock before selling. We typically buy stocks multiple times over multiple years. Every time we sell some stock, we can decide which of the stocks we bought we are selling now, thus indicating the cost price and how long we've held the stock.

If we bought the stock only once, then there is no confusion about what the purchase price was. However, if we bought stock numerous times, we need to decide which 'batch' of stocks we are selling. The effective purchase price of the stocks in those batches will be our cost basis.

Taxation

Remember that our overall tax depends on several other factors. Other (non-stock-related) gains or losses may add to or offset the gains and losses of stock sales. Selling and buying back the same or a similar stock within a short time (known as a 'wash sale') may nullify any losses. Selling stock options and dividends have their own rules. And so on. A qualified tax consultant is the best person to consult with to understand the implications of these.

Cost Basis Methods

Here are the most common methods of specifying cost basis. Not all of these may be applicable for every type of stock transaction. Please check with your broker as to which ones are supported by them.

Also, every country has different laws when it comes to stock income reporting. Countries may force stock income reporting to use only specific basis methods. Check with your broker to understand which methods are relevant for where you are.

• First in, first out (FIFO): We sell the oldest bought shares first, followed by the next oldest one, and so on. This is usually the method that most stock brokerages follow, unless we ask it to be changed.
• Last in, first out (LIFO): We sell the latest bought shares first, then the one just before that, and so on, until we reach the first 'buy'. If the buys and sells were spread over several years, the initial sells may incur the short-term tax rate and the later ones will be taxed at the long-term rate.
• Lowest cost first: We start by selling the shares that had the lowest price when we bought them, and then move up from there.
• Highest cost first: We start by selling the shares that had the highest price first, and then move down from there.
• Average cost: We compute the average cost of a share over all our stock purchases and use that as the cost basis. This method is usually available only for mutual funds.

Summary

We learned about cost basis and the different available methods. Discuss your specific tax needs with a licensed tax professional to understand which methods are relevant and optimal for your case.