How to Calculate the Tax Basis of a Common Equity

When common stocks are sold, the taxes due on them are calculated based on the profit, or capital gain, realized. This can be done by comparing the total cost of the shares with the net proceeds of the sale, either by using the total number of dollars involved or on a cost per share basis. However, this can be complicated by a variety of factors. To reduce your tax liability, it is important to know all the ways to report your tax basis to the IRS.

Difficulty: Moderate

Instructions

Things You'll Need:

• Records of all stock transactions

1. Calculate initial cost. The cost basis for tax purposes always includes commissions or other purchase costs. To calculate the initial tax cost of common equity shares, add the money actually paid for the shares to the total of commissions and fees associated with the sale. Because a per share basis sometimes is more useful when figuring taxes after a sale, also divide the sum by the number of shares purchased. That will give you the per share tax basis.

2. You will need to adjust for subsequent purchases. If you buy more shares or add shares by reinvesting the dividends you receive, it's necessary to adjust the tax basis. It is easier to do this in absolute dollar terms, simply adding the cost of all purchases in a single stock (including commissions). But it also is worthwhile to maintain the tax basis per share for each individual block purchased as well as the tax basis per share for the total block of shares you have bought.

3. You'll have to adjust for splits. A common complication for keeping track of your tax basis is splits and reverse splits. Stock splits change the number of shares and the cost per share, but they don't create or destroy value. In absolute dollar terms, a stock split has no effect. The amount of money you spent on the stock will not change, and if you sell all the stock at once, you will be receiving a lump sum payment in return. But to keep track of your per share tax basis, you will need to figure the new basis based on the split ratio. Here are a couple of examples: For a 5-for-3 split, you would first multiply your original per share basis by 3, then divide it by 5 for your new per share basis. For a 2-for-1 split, you simply would need to divide your original tax basis by 2.

4. Readjust after sales. The major complication to tax basis comes if you decide to sell only part of the shares you own. The IRS allows partial sales to be figured in different ways, and it is best to calculate your tax basis each way before selling a partial block of your stock holding. One way is known as first in, first out, or FIFO. Basically, the shares sold will be compared to the cost of the shares in the order they were purchased, regardless of the total cost basis. For example, if you buy 100 shares at $10 and another 100 at $20, the total per share cost basis is $15. But if you subsequently sell 150 shares at $18, under FIFO the first 100 shares sold will be the first you bought and can be figured to have created a gain of $800, or $8 per share. The remaining 50 shares sold will be figured to have created a loss of $100, or $2 per share. Your tax will be paid on capital gains of $700.

5. Use specific identification. If you keep meticulous records, you can get even more specific than FIFO. The IRS allows you to identify which shares you're selling, and use the original purchase price as the tax basis. Thus, on the sale of your 150 shares at $18, you could report a sale of 100 shares that cost $10, a gain of $8 per share or $800, and 50 that cost $20, a loss of $2 per share or $100. That would result in a total capital gain of $700. However, you also could specify a sale of 100 shares that cost $20, a loss of $2 per share or $200, and 50 that cost $10, a gain of $8 per share or $400. That would be a capital gain of only $200, the least immediate tax liability possible for this particular transaction. Of course, you also could sell 75 shares at each of the two costs (or any combination in between) to create a different immediate capital gains total. In short, the choice of how to report the shares can be tailored to offset other gains or losses in any particular calendar year.

6. Use total basis. If you don't have records of your stock purchases, the IRS requires you use a basis of $0. If you have the records but don't want the hassle of FIFO or specific identification, another way to figure the tax basis is to use the total average tax basis in absolute or per share terms. Under the preceding scenario, your per share cost basis is $15 and your total cost basis is $3,000. By selling 150 shares at $18 per share, you have generated capital gains of $3 per share, or $450. Your cost basis on the remaining 50 shares also would be $15.

Tips & Warnings

• The tax basis of shares received by gift or inheritance are treated differently by the IRS. Shares that were a gift carry the cost basis of the person who originally purchased the shares. So, the recipient would need the same records as the original purchaser in figuring the tax basis, and the recipient would have the same tax liabilities in relation to gains and losses. The cost basis for inherited shares, on the other hand, is the market price of the stock on the day of inheritance. All inherited stock carries the same per share basis regardless of when it was bought.
• Either the FIFO method or designating specific blocks to sell can help generate deductible losses or minimize capital gains when sales occur over multiple calendar years. But each method requires keeping careful records of all transactions and can be more time consuming to compute.

References

• http://www.investopedia.com/ask/answers/05/costbasis.asp

Resources

• How to Calculate Cost Basis
• Calculate the Cost Before You Sell
• How to Calculate Cost Basis Accurately