Cost basis sounds technical, but it can help to think of it as the number that tells the tax journey of an investment: what you put in, adjusted for what happened along the way, compared to what you got out when you sold. Nail it, and you avoid overpaying taxes (or missing a deductible loss). Miss it, and you may leave money on the table—or invite questions you don’t want from the IRS. Let’s walk through what builds your basis, what changes it, how to track it, and how to use it to your advantage.
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What Cost Basis Is—and Why It Matters
At its core, cost basis is the original value of an asset, including what you paid and certain acquisition costs, that becomes the starting line for your gain or loss. When you sell, it’s simply sale price minus adjusted basis. The word “adjusted” is doing real work here: splits, dividend reinvestments, return of capital, and other events can move your basis up or down. Keep those adjustments current, and tax time gets much easier (and cheaper).
The Basics: Getting Your Starting Line Right
Your opening basis is usually the purchase price plus related costs—think trade commissions, fund sales loads, or fees that were necessary to acquire the asset. Buy 100 shares at $20 and pay a $10 commission, and you didn’t invest $2,000; you invested $2,010, which is your basis.
From there, life happens. A stock split changes your share count and your per-share basis, but not your total basis. Dividend reinvestments quietly add new lots—each with its own cost and date—so basis rises as you plow those dividends back in. Return of capital is the opposite: it’s not a taxable dividend today, but it lowers your basis and increases potential gains later. For real estate, capital improvements (a new roof, not a routine repair) increase basis, while depreciation on rentals reduces it.
Going beyond those usual suspects, there are more technical “adjustments”: corporate actions like spin-offs and mergers that reallocate basis between securities; wash-sale rules that defer a loss and attach it to replacement shares; employee equity (RSUs, ESPPs, options) with basis rules tied to vest or exercise; and gifts vs. inheritances, which often come with “carryover” basis in the former and a step-up (or step-down) to date-of-death value in the latter.
The math at sale is still straightforward: sell at $3,000 and your adjusted basis is $2,010, you have a $990 gain; sell at $1,800 and it’s a $210 loss. The key is making sure that “adjusted” number reflects reality.
How You Track Basis: The Methods That Drive Your Tax Bill
Most investors accumulate multiple “lots” of the same holding over time. Each lot has its own basis and holding period, and when you sell, your advisor needs to know which lots you’re letting go. That choice can change your tax rate and your total bill.
- FIFO (First In, First Out): The default at many firms. You’re selling the oldest shares first, which can be convenient if you’ve held them long enough to qualify for long-term rates—but painful if those oldest shares have the lowest basis and trigger bigger gains.
- LIFO (Last In, First Out): Newest shares out first. It’s less common for brokerage accounts but sometimes available. It can suppress gains if your most recent purchases were higher priced, yet it can also surface short-term gains that are taxed at ordinary-income rates. Use with care.
- Specific Identification: The power tool. You tell your broker exactly which lots to sell—ideally the high-basis shares when you want to minimize gains, or low-basis long-term shares when you’re intentionally harvesting gains (even at a 0% long-term bracket, if you qualify). The catch is procedural: you must designate lots at or before the trade and keep confirmations that show those lots; otherwise the system typically defaults to FIFO.
- Average Cost (often used for mutual funds): Total dollars invested divided by total shares gives a single, blended per-share basis. It’s wonderfully simple, but the simplicity comes at a cost: you lose the surgical control that Specific ID provides. Many mutual fund investors accept that trade-off; for ETFs and individual stocks, the flexibility of lot-level control is usually more valuable.
Taxes: Rates, Reporting, and Why Timing Matters
Your tax rate depends on how long you held the shares you sold. Short-term gains (held one year or less) are taxed at ordinary rates; long-term gains (held more than one year) get preferential rates. A method like FIFO tends to surface long-held shares by default; Specific ID lets you target them deliberately. Losses offset gains and, to a limited extent, even reduce ordinary income, but beware the 30-day wash-sale window around loss harvests if you repurchase the same or “substantially identical” security.
On the paperwork side, your broker reports sales on Form 1099-B. For covered shares (generally modern lots acquired after IRS tracking rules took effect), the broker also reports basis and holding period to the IRS. For very old or transferred-in lots that are noncovered, you (or your tax pro) may need to supply basis. When you move accounts between firms, always request a full basis transfer and verify the incoming lots—“unknown basis” is not a fun scavenger hunt in April.
Real-World Situations You’ll Actually Encounter
DRIPs and frequent contributions
Reinvested dividends and monthly buys create lots of tiny lots. Your broker usually tracks them well; your job is to verify it matches your records, especially after transfers.
Corporate actions
Splits are easy; spin-offs and mergers are nuanced. Firms typically post basis-allocation memos—save them. If something looks off, ask the broker to review the adjustment.
Wash sales
Selling at a loss while a DRIP or auto-buy is running can create wash sales you didn’t intend. If you’re harvesting losses, pause reinvestments and avoid repurchasing the same (or substantially identical) holding for 30 days before and after the sale.
Employee equity
For RSUs, the income at vest becomes your basis; same-day sales often show little or no gain. ESPPs can add a discount element to ordinary income depending on the plan and holding period. Options (NSOs vs. ISOs) layer in wage income and AMT considerations that affect basis—keep every vest, exercise, and sale confirmation.
Real estate
Improvements increase basis; depreciation on rentals reduces it and may be taxed on sale via depreciation recapture. Start a simple basis log and throw receipts in a folder—you’ll be glad later.
Gifts and inheritance
Gifts typically come with carryover basis (and possibly the donor’s holding period); inheritances usually step to fair market value at death, which can wipe out large embedded gains.
Choosing a Method (and Using It Well)
If you want control, choose Specific Identification and make it your default workflow. It’s the best way to steer gains and losses toward the outcome you actually want. If you prefer simplicity and hold mainly mutual funds, Average Cost is fine, as long as you accept the trade-off. FIFO remains serviceable when your lots are mostly long-term and similar in price; LIFO tends to be the niche choice for specific, short-term needs.
To do Specific ID right, flip the setting on in your brokerage, select lots before you submit the order, and save both the order ticket and the fill confirmation that list those lots. After settlement, spot-check your realized-gains report to confirm it stuck.
Common Mistakes (and Quick Fixes)
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Forgetting reinvested dividends. You understate basis and overpay tax. Fix: make sure every DRIP lot is included.
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Leaving DRIP on during loss harvesting. You trigger wash sales by accident. Fix: pause reinvestments 31 days before and after.
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Transferring accounts without basis. New firm shows “unknown.” Fix: request a basis transfer and provide old statements if needed.
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Letting the default pick for you. FIFO creates gains you didn’t intend. Fix: use Specific ID and choose lots deliberately.
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Mixing short- and long-term lots haphazardly. You increase taxes. Fix: prioritize long-term lots when the gain is similar.
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Skipping real-estate adjustments. You miss improvements or depreciation. Fix: keep a running basis log per property.
Quick Checklist
(Use This at Year-End or Before a Sale)
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Confirm your basis method in each account.
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Export your lot history and save it with tax docs.
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Turn off DRIP before planned loss harvesting.
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For equity comp, save every vest/exercise/sale confirmation.
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For real estate, update your basis log after each project.
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After corporate actions, verify the broker’s basis changes.
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Before selling, pick lots with Specific ID and confirm the ticket.
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At year-end, match realized gains/losses to your broader tax plan.
Short Worked Examples
DRIP investor using Specific ID. You bought 200 shares at $25, then reinvested dividends and added 18 small lots around $32. When you sell 100 shares, you choose the highest-basis DRIP lots first. Your gain shrinks, and most of what’s left is long-term.
Loss harvest without a wash sale. Your S&P 500 ETF is down 8%. You sell it and immediately buy a broader total-market ETF that is not substantially identical. You stay invested, book the loss, and after 31 days you can switch back if you want.
Real-estate improvement. You purchased a home for $400,000, then added a $25,000 roof and a $35,000 kitchen. Your adjusted basis is now $460,000 (plus selling costs when you eventually sell), which directly reduces your taxable gain.
RSU vest and sale. At vest, 300 RSU shares at $50 create $15,000 of W-2 income; that $50 becomes your basis. Sell the same day at $50 and there’s basically no gain; sell later at $55 and you’ll realize $5 per share in capital gains from the vest date.
The Big Takeaways
Cost basis is your investment’s starting line for taxes, and adjustments—splits, reinvestments, return of capital, improvements—move that line over time. Your tracking method (FIFO, LIFO, Specific ID, Average Cost) isn’t just admin; it shapes your tax outcome. Holding period drives your rate, records make everything easier, and Specific ID often gives long-term investors the most control. Most of all, set up a simple system now—lot control on trades, confirmations saved, DRIPs paused when needed—so you’re not reconstructing your financial history at tax time.
Final Word
You do not need to memorize every rule. You do need a clean, simple system. Pick a basis method on purpose. Keep your confirmations. Match sales to your tax plan. And when life gets complex—employee equity, spin‑offs, multiple brokers—get help. A fee‑only fiduciary or tax professional can align basis tracking with your broader strategy, so you spend less time untangling paperwork and more time keeping the gains you earned.
