Cost basis is the original price of an asset you purchased. For a business, cost basis may be the cost of machinery, equipment or business supplies. For an individual, the cost basis of an asset such as a stock is its original purchase price. While cost basis may seem straightforward, it can become complicated if you reinvest earnings on your asset, therefore changing your initial cost basis. Since cost basis is used to calculate total capital gains on your taxes, a change in your cost basis has tax implications.

Cost Basis Example

You purchase 10 shares of Stock A for $10 per share. Your cost basis on the investment is $100. Now, imagine you earn $5 in dividends over the next year. Instead of allowing those dividends to hit your bank account, you reinvest them immediately. You then receive $10 in capital gains over the next year and $5 in dividends. Your total earnings over time have been $20.

If you were to take your initial cost bases of $100, you would have received returns of 20 percent on your investment. You would be taxed on $20 of capital gains. However, you actually spent $100 plus an additional $5 in dividends on the shares, totaling $105. You should only be taxed for $15 of capital gains.

Cost Basis in Real Estate

When you own a secondary property beyond your primary residence, it is particularly important to remember to modify your cost basis if you reinvest earnings into improvements of that property. For example, imagine you purchase an investment property for $250,000. At the time of sale, you secure a $370,000 payment for the property. It may appear that your profit, or capital gains, was $120,000. This would result in a very large tax payment. However, this does not account for the $60,000 of renovations you made to improve the property. Once you add that $60,000 to your cost basis, you will see your actual taxable capital gains is only $60,000, only half of the first calculation. 

Recording Cost Basis

The most important thing to remember about cost basis is the need to constantly record your expenses on any asset. Whether you are keeping records for your personal accounting, a specific investment or your business as a whole, you should carefully record each expense pertaining to a valued asset. In addition to recording the expense, it is critical to save receipts. This is not important with a stock portfolio. With an item like real estate, though, you should save receipts for supplies, materials and labor costs spent in order to raise the value of the property.

Tips for Calculating Cost Basis

If you are using a securities brokerage for management of your portfolio, they will send you a total calculation of your cost basis annually. It is still wise to personally keep track so you can verify the records once they are sent your way. If you receive an asset as a gift, your cost basis is equal to the original cost basis of the owner. 

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