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Tax Strategies & Credits

The Importance of Knowing Your Investment Basis

by
Gordon W. McNamee
on
5/3/2015
The Importance of Knowing Your Investment Basis

Some people think that buying and selling stocks is a straightforward and simple process. You choose a stock, you buy it and hold on to it for a period of time, and then you eventually sell it (hopefully at a profit). But when tax time rolls around and they need to record their gains or losses and are asked what their investment basis was, many taxpayers have no idea what that is, and once they learn the definition they have no idea how to determine what it is because they haven't kept appropriate records.

Whether you're talking about investments in securities, stocks, bonds, mutual funds or any other asset, your profit or loss can only be measured with knowledge of what the security's value was at the time that it came into your possession, whether you purchased it or it was given to you as a gift or as part of an inheritance. For a purchase, the investment basis is the amount that the investment initially cost, but when an asset has been bequeathed to you, the investment basis is the fair market value on the assigned valuation date, which may be the decedent's day of death, but may also be an alternative date assigned by the estate's executor. If you are given a security as a gift then the asset is valued based on the fair market value when the person who gifts it to you acquired it if there's a gain, and on the fair market value on the date that you receive the fit if it is a loss.

Divorces have their own specific rules regarding the establishment of an investment basis. When the couple's assets are divided and one spouse acquires securities from the other in a division of property, they retain the same investment basis as they had been when the marriage was intact. Another complication that can be confusing is when shares of a stock are purchased at different times and at different prices, and then a percentage of them are sold. Calculating the investment basis, and therefore the profit or loss, usually follows a "first in, first out" rule, but it is possible for an investor to use a method known as "specific identification" that allows an investor to specify a particular block of the stocks in order to manipulate investment basis.

Investment basis can be extremely complex and fluid, as there are a number of different actions during the ownership of an asset that can create a change in value.

These include:

  • Stock splits and reverse splits
  • Return of capital
  • Broker's commissions
  • Interest taken as income under the original issue discount rules
  • Acquisition costs
  • Depletion
  • Reinvested cash dividends
  • Stock dividends
  • Additional investments
  • Interest previously taken into income under an election under the accrued market discount rules
  • Attorney's fees
  • Casualty losses

Any of these changes can have either a positive or negative impact on an asset's investment basis, and because of that it is essential that a security's owner keeps meticulous records of every event.

Here is a rundown of some of the basis adjustments that most frequently need to be made:

  • Stock dividends can be paid out as either taxable or nontaxable payments, and those that are taxable mean that the investor is given more stock that has a basis that is the same as the dividend itself. However, nontaxable dividends also increase the number of shares owned without changing the basis. The only way that the taxpayer can adjust the basis for that specific block is if they can associate the dividends with a specific block of stock. Otherwise, tax law requires that the investment basis of all of the taxpayer's holdings of that stock are impacted.
  • Reinvesting cash dividends is an option that is commonly offered to investors in lieu of taking dividends as cash, but when this option is chosen it is the same as purchasing new shares of stock. Without keeping careful records of the investment basis of stock purchased with each of these reinvested dividends, it is nearly impossible to determine overall gains and losses, and therefore when the time comes to sell, it is difficult to determine the amount of taxes that are owed on gains or deductible as a loss.
  • Stock splits generally happen when a stock's price becomes so high that it becomes difficult to attract investment from small investors. If you already hold the stock they are a great way to increase your holdings, but it is important to keep records of every time that they happen, because at the same time that they double the number of shares owned, they also reduce the basis of each share by half. The same is true for reverse splits, which halve the number of shares but double the investment basis.
  • A return of capital describes a nontaxable portion of a stockholder's initial investment being returned to them. When this happens, the original investment basis is reduced. These returns can be distributed repeatedly, and can actually reach the point where the amount of capital that is returned exceeds the original investment. When this happens, the capital is taxable - otherwise the investor would have a negative basis, and that is not permitted.
  • The fees that a broker gets paid when a stock and bond transaction takes place is deductible, but because it is usually rolled into the purchase price of a stock it can be difficult to extricate it from the investment basis. It is important to do so, as when a sale takes place and gains or losses are calculated, the net sales cost is what is used.
  • Stock spin offs occur when a company creates new or additional companies, such as when they split up or merge with others. Whenever this happens, investors in the original company are notified of the impact of the transaction on the investment basis of the shares that they own. It is essential that this information is retained and kept available, as attempting to recreate the data in the future is extremely challenging.

Though we live in an increasingly paper-free society in which people feel that they can investigate and access any information that they need by searching online, there are some records that it is extremely helpful to keep track of, and those pertaining to investment basis are among the most important. If you have tax related questions to this article, contact Upland Tax Expert Gordon McNamee, CPA at (909) 949-4898.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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