Basis Adjustments Explained

When it comes to taxes, keeping precise records is a must. As an investor, your portfolio may include a variety of securities including mutual funds, stocks and bonds. When you decide to sell your shares, you will want to maximize your losses and reduce your gains for tax purposes. The amount of gain or loss is determined by your tax basis in the investment (asset), which is why it is essential to keep track of the basis in each of your investments.

What is Basis? In most cases, your basis in an investment begins with the purchase price of the investment. However, this does not apply if you acquired the investment via inheritance or gift. The basis for inherited assets starts with the FMV of the assets on the death date of the descendant or an alternative valuation date, as selected by the executor of the estate. The donor's basis is the basis for gain on assets acquired by gift. The basis for loss is the FMV of the asset on the date of the gift. When an acquired asset results from a property division in a divorce, the basis is retained from when it was owned jointly by the couple.

The basis does not have a fixed value; it may change during the period in which the asset is owned and certain events can adjust the basis. These events for investment assets are:

•       Reinvested cash dividends,

•       Stock splits,

•       Reverse splits,

•       Stock dividends,

•       Return of capital,

•       Other investments,

•       Broker’s commissions,

•       Interest previously taken into income under an election under the accrued market discount rules,

•       Interest taken into income under the original issue discount rules,

•       Attorney's fees,

•       Acquisition costs,

•       Casualty losses, etc. 

Recordkeeping is essential because these events may increase or decrease the tax basis in the investment.  

Selling a portion of an investment can also affect the basis. For example, let's say that you purchased 100 shares of a particular stock in 2010 at a price of $10 per share and an additional 100 in 2014 at $20 per share. You then plan to sell 100 shares of the stock at $30 per share. According to the rule of “first in - first out," there would be a gain of $20 per share. However, if a specific block can be identified for the shares, as in the case of the 100 shares purchased in 2014, then there would only be a gain of $10 per share.This method is called the “specific identification” method.

The basis adjustments that are commonly encountered are the following:

•       Reinvested cash dividends – Many investors have the chance to reinvest dividends instead of taking them in cash. The plans actually allow them to purchase additional sales with their dividends that are taxable. Without precise record keeping, the investor is unable to prove the exact amount that he or she paid for the shares and will also be unable to determine amount of gain that is subject to taxation (or the amount of loss that can be deducted) when the additional shares are sold.

•       Stock dividends – An investor may receive both taxable and nontaxable stock dividends.  Taxable stock dividends provide the investor with additional stock with a basis that is equal to the taxable stock dividend.  For dividends that are nontaxable, the quantity of shares that are owned increases, but the basis remains the same.  If the dividends can be associated with a specific block of stock, then the basis of that block can be adjusted accordingly.  If not, the adjustment applies to all of the holdings in that particular stock.

•       Return of capital – A return of capital is a nontaxable return of a portion of the investment. As a result, the return of capital reduces the investor’s basis in the security.  For example, let's say an investor holds 100 shares of ABC Corporation that cost $1,000 ($10 per share), and the corporation distributes to him a $100 nontaxable return of capital.  His basis in the stock is lowered to $900 ($1,000 - $100) or $9.00 per share.   Over time, if the return of capital exceeds his basis in the investment, then the excess will become taxable because he cannot have a basis that is negative.

•       Stock splits – Stock splits can be difficult to figure out if they are not tracked as they occur.  As an example, an investor owns 100 shares of XYZ Corporation for which he paid $2,000 ($20 a share).  At a later date, the corporation splits the stock 2 for 1.  The outcome of this event is that he now owns 200 shares, but his basis in each has been lowered to $10 per share (200 shares times $10 equals $2,000 – the cost of the original shares). Generally, this happens when the “per share value of stocks” becomes too high for small investors to purchase 100 share blocks.  Be careful of reverse splits, which have opposite results. 

•       Stock spin-off – Sometimes, corporations spin-off additional companies.  A well-known example of this is the breakup of AT&T back in the 1980’s into regional phone companies. These phone companies then later split into or merged with additional companies.  Every time a transaction like this occurs, the corporation provides documentation on how to split the prior basis between the resulting companies.  Tracking such events as they occur is extremely important because it can be difficult to figure things out after several years have passed.

  • Broker fees - Broker fees are considered a deductible expense and they are typically already accounted for in most stock and bond transactions.  The purchase price of a block of stock usually includes the broker fees, and the gross proceeds of sale, which is the sales price as reported to the IRS, is the net of the sales costs. 

Have a question about investment basis and your taxes? Call us at (831) 462-0330 and let's discuss your financial future.