In this week’s post, I explain the basics of cost basis.
In future weeks, we will be exploring a number of different tax topics involving investments, such as the taxation of dividends, capital gains, and rental property. However, before we begin discussing these topics, it is important to understand cost basis.
This post continues our tax series that started several weeks ago. Before learning about cost basis, it is important to understand the basic income tax formula.
What is cost basis?
Cost basis is the investment in an asset that is used to calculate the gain or loss when the asset is sold. For example, if you buy a share of stock for $100 and then sell it for $120, your cost basis in the share of stock would be $100 and your gain would be $20 (120 – 100 = 20). There can be certain adjustments to cost basis, which we will discuss below.
Adjustments to basis
Depending on the type of asset, there can be a variety of adjustments to initial cost basis. Here are several examples (list is not exhaustive):
Property improvements – The basis of a property will be increased for major improvements, such as an addition. For example, if a house is purchased for $200k, and $50k is spent adding an additional bedroom, the adjusted basis of the property would be $250k (200 + 50 = 250).
Depreciation – Owners of certain kinds of capital assets are allowed to deduct the cost of the asset over time through depreciation. Depreciation reduces an asset’s adjusted basis. For example, an investor buys a duplex for $800k. Over a number of years she takes $200k of depreciation, reducing her income in the years in which the depreciation is taken. Her adjusted basis would now be $600k (800 – 200 = 600). When sold, the depreciation may need to be “recaptured,” a concept that is beyond the scope of this post.
Return of capital distribution – Certain types of investments will periodically return capital to shareholders. A return of capital distribution reduces an investor’s basis in the stock/company. Initial basis is made up of the purchase cost, so when the initial investment is returned basis is reduced.
Original issue discount (OID) and zero-coupon bonds – Unlike fixed-coupon bonds that only make periodic interest payments, original issue discount (OID) and zero-coupon bonds are issued below their face value. The bondholders will realize the difference between the issue price and the face value upon maturity - the discount (which the bondholders eventually realize) is a form of interest. Even though the investor will not receive the money until maturity, taxes are owed each year on the “imputed interest.” This imputed interest also increases the bondholder’s basis.
Examples
Jean buys a rental house for $370k. She spends $40k adding an additional bedroom to the house. After a number of years, she has taken $60k in depreciation on the property. Her adjusted basis is $350k. As mentioned earlier, the depreciation may need to be recaptured if/when the house is sold:
Rick buys a share of a real estate investment trust (REIT) for $50. The REIT has a $5/share distribution. 40% of this distribution is a return of capital ($2 a share). After the distribution, Rick’s adjusted basis of his share is $48. A couple of months later, he sells the share for $60. The adjusted basis is used to calculate the gain of $12 (60 - 48 = 12):
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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