Cost Basis Calculation

Basis represents the amount of your investment in property for tax purposes. You use basis to calculate depreciation, amortization, depletion, casualty losses, and most importantly, gain or loss when you sell or dispose of property.

The Fundamental Gain/Loss Formula

Every capital gains calculation starts with basis:

• Gain = Amount Realized - Adjusted Basis
• Loss = Adjusted Basis - Amount Realized

The amount realized includes cash received, the fair market value of property or services received, plus any liabilities the buyer assumes.

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Original Basis Rules

Purchased Property

When you purchase property, your basis equals the cost. Cost includes:

• Purchase price paid for the property
• Acquisition costs directly related to the purchase:
  • Sales commissions
  • Legal fees
  • Recording fees
  • Transfer taxes
  • Title insurance
  • Survey costs

Example: Sarah purchases rental property for $200,000, pays $6,000 in closing costs (title insurance, recording fees, legal fees), and $4,000 in transfer taxes. Her original basis is $210,000 ($200,000 + $6,000 + $4,000).

Important: You cannot include loan-related costs (points, mortgage insurance, loan origination fees) in basis. These are either deductible interest or amortized separately.

Constructed Property

If you construct property, your basis equals the total cost of construction, including:

• Materials and supplies
• Labor costs
• Architect and engineering fees
• Permits and licenses
• Equipment rental

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Adjusted Basis

Your basis changes over time through adjustments. The formula is:

Adjusted Basis = Original Basis + Increases - Decreases

Increases to Basis

• Capital improvements (additions, renovations that extend useful life)
• Legal fees to defend or perfect title
• Assessments for local improvements (sidewalks, roads)
• Restoration costs after casualty (not covered by insurance)

Decreases to Basis

• Depreciation allowed or allowable
• Casualty or theft losses deducted
• Insurance reimbursements received
• Section 179 deductions taken
• Credits received (energy credits, etc.)
• Rebates from manufacturer

Example: Tom buys equipment for $50,000. Over 5 years, he claims $35,000 in depreciation. He then adds a $5,000 upgrade. His adjusted basis is: $50,000 - $35,000 + $5,000 = $20,000.

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Stock Basis Methods

When selling stocks purchased at different times and prices, the IRS requires you to determine which shares you sold. Three methods exist:

1. Specific Identification

You designate exactly which shares you are selling. This requires:

• Adequate identification at time of sale
• Records proving which shares were sold
• Communication with your broker specifying the lots

Advantage: Maximum tax planning flexibility - you can choose shares with highest or lowest basis.

2. FIFO (First In, First Out)

The default method if you cannot adequately identify shares. The IRS assumes you sell your oldest shares first.

Example: You purchased:

• 100 shares at $20 in January 2022
• 100 shares at $30 in June 2023

You sell 100 shares at $35. Under FIFO, you sold the $20 shares, recognizing a $1,500 gain ($3,500 - $2,000).

Warning: FIFO often results in higher taxable gains because older shares typically have lower basis due to asset appreciation over time.

3. Average Cost (Mutual Funds Only)

Available only for mutual fund shares and dividend reinvestment plans. Calculate by dividing total cost by total shares.

Example: You own 500 mutual fund shares with a total cost of $10,000. Your average cost basis is $20 per share.

Once you use average cost for a mutual fund, the basis of existing shares is locked in - you can only change methods for later-acquired shares.

Broker Reporting (Form 1099-B)

Brokers must report cost basis to both you and the IRS for covered securities:

For non-covered securities (purchased before these dates), brokers report sales but not basis - you must track and report basis yourself on Form 8949.

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Basis in Converted Property

Personal to Business Use

When you convert personal property to business use, the depreciable basis is the LOWER of:

1. Your adjusted basis (usually cost) on the date of conversion, OR
2. The fair market value (FMV) at conversion

Why this rule exists: It prevents claiming depreciation deductions for value declines that occurred during personal use.

Example: Maria bought a car for $30,000 for personal use. Three years later, she converts it to business use when the FMV is $18,000. Her depreciable basis is $18,000 (lower of cost or FMV).

Dual Basis for Gain/Loss on Sale:

When you later sell converted property:

• Calculate gain using original cost basis (adjusted for depreciation)
• Calculate loss using FMV at conversion (adjusted for depreciation)
• If sale price falls between, you have neither gain nor loss

Business to Personal Use

When converting business property to personal use, your basis is the adjusted basis from business use (original basis minus depreciation claimed).

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Stock Splits and Stock Dividends

Stock Splits

A stock split does not change your total basis - it only changes your per-share basis.

Example: You own 100 shares with $1,500 total basis ($15 per share). After a 2-for-1 split, you own 200 shares. Total basis remains $1,500, but per-share basis is now $7.50.

Stock Dividends

Non-taxable stock dividends work the same as splits - allocate your existing basis proportionally among old and new shares.

Example: You own 400 shares with $13,200 basis ($33/share). You receive a 10% stock dividend (40 new shares). You now own 440 shares with per-share basis of $30 ($13,200 / 440).

Taxable stock dividends are rare but do occur. The new shares' basis equals the amount included in income (their FMV on distribution date).

Holding Period

New shares from splits or non-taxable dividends take the same holding period as original shares. This affects whether gains are long-term or short-term.

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Wash Sales Effect on Basis

A wash sale occurs when you sell stock at a loss and purchase substantially identical stock within 30 days before or after the sale.

The Basis Adjustment Rule

When a wash sale disallows your loss:

New Stock Basis = Cost of New Stock + Disallowed Loss

The disallowed loss adds to the basis of replacement stock, preserving your economic loss for recognition on a future sale.

Example:

1. You buy 100 shares of XYZ for $1,000
2. You sell for $800 (creating $200 loss)
3. Within 30 days, you buy 100 shares for $600
4. The $200 loss is disallowed (wash sale)
5. New basis = $600 + $200 = $800

When you eventually sell the replacement stock (outside the wash sale window), you use the $800 basis, effectively deferring - not losing - your original loss.

Critical Exception: If replacement stock is purchased in an IRA or Roth IRA, the wash sale still applies, but the basis in the IRA is not increased. The disallowed loss is permanently lost, not deferred.

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EA Exam Tips

1. Remember the basis formula: Original + Improvements - Depreciation/Losses = Adjusted Basis
2. FIFO is the default for stocks unless you specifically identify shares
3. Average cost is mutual funds ONLY - never individual stocks
4. Lower of cost or FMV applies when converting personal to business property
5. Wash sale losses are deferred, not lost (except in IRAs)