Subject: Tax Code - Capital Gains Cost Basis
Last-Revised: 7 Jan 2000
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott (contact me)
This article discusses how to determine the cost basis of a security according to the rules of the US tax code. The most common need for the cost basis of a security like stock is to report the proper gain or loss when that security is sold. This article sketches the issues for the simple case (you bought a security) and a couple less simple cases (you are given or inherit a security). Of course you might have not just one share but instead many hundreds; the word "security" is used here for simplicity.
- You bought the security
The cost basis is simply the money you paid when you bought the
security, including any commissions that you paid to acquire that
security. For example, if you bought 10 shares of IBM at 100 and paid
$29.95 in commission to do so, your cost basis would be 1029.95.
This example lists just a single purchase of a security. If you
accumulated stock over the course of many purchases, the total cost
basis is still just the cost of all the purchases including
commissions. The situation gets a bit more complex if you sell only a
portion of an investment; see the FAQ article about
computing capital gains for more information about this.
- You were given the security
To oversimplify the issue, if the shares are given away at a gain, the
donor's cost basis and acquisition date are used. If the shares are
given away at a loss, the fair market value as of the date of gift
must be used to calculate a subsequent sale at a loss, while the
donor's cost basis must be used to calculate a subsequent sale at a
gain. In the case of a gift at a loss, which is later sold at a loss,
the date of the gift is used as the "acquisition date" of that stock.
All of this means that an individual can transfer a gain but not a
loss to another individual. Read on for all the details.
The date when the gift is made is important. To figure the cost basis, the fair market value (FMV) of the gift on the gift date must be determined. A local library's microfilm archive might be the best resource to find the value of shares on a particular date. But be cautious about stock splits and other stock dividends! It's wise to consult the S&P stock guide, the Value Line Investment Survey, or the company that issued the shares for a history of the stock price, stock splits and dividends, etc.
In the happiest and simplest case, the donor bought shares for a pittance, and donated them to some lucky individual, maybe you, after the shares had appreciated dramatically. That individual immediately sold the shares. The fair market value (FMV) of the shares on the gift date far exceeded the original cost basis, so the recipient's cost basis is the same as the donor's cost basis (possibly small, but definitely NOT zero).
For example, the donor's cost basis is $20, and the FMV on the date of the gift is $100. The cost basis that the recipient must use is $20. On the other hand if the shares were sold for only $5, the same cost basis is used, and the loss is $15. In both cases, the acquisition date that must be reported is the same as the donor's acquisition date.
The other possibility, of course, is that the share's FMV on the gift date was less than the original cost basis thanks to some decline in value. In this case, the gift assumes a dual cost basis that is not determined until the shares are sold. The donor's cost basis must be used to determine the gain if the shares are sold at a gain. The FMV on the date of the gift must be used if the shares are sold at a loss.
For example, the donor's cost basis is $20, and the FMV on the date of the gift is $10, thus establishing a dual cost basis. Here are three possibilities.
- Case 1: If the shares are subsequently sold for $25, this is a gain with respect to the donor's original cost basis and the FMV, so the recipient consequently reports a gain of $5, namely $25 (sales price) less 20 (donor's cost basis).
- Case 2: If the shares are sold for $8, this is a loss with respect to the donor's original cost basis and the FMV, so the recipient consequently reports a loss of $2, namely $8 (sales price) less $10 (FMV on gift date).
- Case 3: Here's where it gets complicated. If the shares are
sold for $15, representing a loss with respect to the donor's cost
basis but a gain with respect to the FMV on the gift date, what cost
basis should the recipient use?
- If the donor's cost basis of $20 is used, this would produce a loss for the recipient. However, the $20 can be used only when the recipient has a gain, so that's out.
- If the FMV of $10 is used, this would produce a gain for the recipient. However, the $10 can be used only when the recipient has a loss, so that's out too.
The acquisition date that must be reported depends on the cost basis, and is pretty straightforward. If the donor's cost basis is used, use the donor's acquisition date, and if the FMV on the date of the gift is used, use the date of the gift.
The IRS is light on advice as to how to report a transaction where the stock was given at a loss, and the sale produces neither gain nor loss. If you report the net sales price and then show the cost basis equal to the sales price, you end up with no gain. You can choose to use either the date of gift or original date as your acquisition date, since no gain or loss makes it a pretty much "don't care" condition.
- You inherit a security
The cost basis is simply the value of the security on the date of the
person's death who bequeathed that security to you. (The accountant
lingo for this is "when the stock was inherited, its cost basis was
stepped up to fair market value on date of death".) The price may be
lower on the date of death, which means the price adjustment is really
a step down, but that does not change the rule. The easiest way to
get the price for very old acquisition dates may be to look in a
library's archive (probably on microfiche or CD-ROM) of the Wall
Street Journal or the New York Times. Don't forget about stock splits
while doing the research.
In rare cases, the executor will choose to use an "alternate valuation date" instead of date of death. The alternate valuation date, always 6 months after death, can be chosen only when it will reduce the estate tax, and if chosen, must be used for all property of the estate. An executor who makes this election should notify the heirs of the value used.
Note that when figuring capital gains taxes, inherited property is always long term, per se. In fact if you glance at Pub 550 it asks you to not use an acquisition date for inherited property but to write "INH" to indicate it is inherited property.
Be careful of reinvested dividends! If a stock paid dividends and the dividends were reinvested, computation of a fair cost basis requires a bit of work. All reinvested dividends need to be added to the cost basis, otherwise the cost basis will be much too low and the person who sells the security will pay too much tax. If the dividend payment and reinvestment records are not available, you need to reconstruct them. Find out from old Wall Street Journals or New York Times financial sections how much the dividend was each year since the stock was acquired or inherited, and use the number of shares and price per share on the dividend pay date. You might use a spreadsheet to show number of shares each year, amount of dividend, price at time of reinvestment, etc. This requires a good deal of researching the dividend amounts and the share price.
If computing the cost basis of some security looks hopeless, here's an alternative to consider: donate some or all the shares to charity. If you normally make donations to your church, alumni association, or other charity, it is quite easy to persuade them to accept stock instead of cash. By doing so, you never have to calculate gains nor list the sale as income on your tax return. Moreover, if the stock was held more than a year (long-term gain), you get to itemize the charitable deduction at fair market value on the date of gift. Note that stock gifted to charity and held short term can be deducted at the lower of cost basis or fair market value. This implies that stock bought with reinvested dividends within a year of the gift would be limited to the lower of fair market value or cost basis.
For the last word on the cost basis issue, see IRS Publication 551, "Basis of Assets."
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