The cost basis of any investment is the original value of an asset adjusted for stock splits, dividends and capital distributions. It is used to calculate the capital gain or loss on an investment for tax purposes.
At the most basic level, the cost basis of an investment is just the total amount invested into the company plus any commissions involved in the purchase. This can either be described in terms of the dollar amount of the investment, or the effective per share price that you paid for the investment.
The calculation of cost basis can be complicated, however, due to the many changes that will occur in the financial markets such as splits and takeovers. For the sake of simplicity, we will not include commissions in the following examples, but this can be done simply by adding the commission amount to the investment amount ($10,000 + $100 in commissions = $10,100 cost basis).
Imagine that you invested $10,000 in ABC Inc. which gave you 1,000 shares in the company. The cost basis of the investment is $10,000, but it is more often expressed in terms of a per share basis, so for this investment it would be $10 ($10,000/1,000). After a year has passed, the value of the investment has risen to $15 per share, and you decide to sell. In this case, you will need to know your cost basis to calculate the tax amount for which you are liable. Your investment has risen to $15,000 from $10,000, so you face capital gains tax on the $5,000 ($15 - $10 x 1,000 shares). (For further reading, see A Long-Term Mindset Meets Dreaded Capital Gains Tax and Tax Tips For The Individual Investor .)
If the company splits its shares, this will affect your cost basis per share. Remember, however, that while a split changes an investor's number of shares outstanding, it is a cosmetic change that affects neither the actual value of the original investment, nor the current investment. Continuing with the above example, imagine that the company issued a 2:1 stock split where one old share gets you two new shares. You can calculate you cost basis per share in two ways: First, you can take the original investment amount ($10,000) and divide it by the new
amount of shares you hold (2,000 shares) to arrive at the new per share cost basis ($5 $10,000/2,000). The other way is to take your previous cost basis per share ($10) and divide it by the split factor (2:1). So in this case, you would divide $10 by 2 to get to $5. (For more insight, check out Understanding Stock Splits .)
However, if the company's share price has fallen to $5 and you want to invest another $10,000 (2,000 shares) at this discounted price, this will change the total cost basis of your investment in that company. There are several issues that come up when numerous investments have been made. The Internal Revenue Service (IRS) says that if you can identify the shares that have been sold, then their cost basis can be used. For example, if you sell the original 1,000 shares, your cost basis is $10. This is not always easy to do, so if you can't make this identification, the IRS says you need to use a first in, first out (FIFO) method. Therefore, if you were to sell 1,500 shares, the first 1,000 shares would be based on the original or oldest cost basis of $10, followed by 500 shares at a cost basis of $5. This would leave you with 1,500 shares at a cost basis of $5 to be sold at another time.
In the event that the shares were given to you as a gift, your cost basis is the cost basis of the original holder, or the person who gave you the gift. If the shares are trading at a lower price than when the shares were gifted, the lower rate is the cost basis. If the shares were given to you as inheritance, the cost basis of the shares for the inheritor is the current market price of the shares on the date of the original owner's death. There are so many different situations that will affect your cost basis and because of its importance with regards to taxes, if you are in a situation in which your true cost basis is unclear, please consult a financial advisor, accountant or tax lawyer.
For more on how to use cost basis, check out Using Tax Lots: A Way To Minimize Taxes .