When it comes to year-end tax planning, one of the most important topics to understand is the capital gains tax. Before you can calculate your potential capital gains and losses, however, you need to know what your cost basis is for that investment.
Cost basis is the figure that is subtracted from the sale price to calculate the amount of the capital gain or loss. In most cases, the cost basis is the amount that you paid for the security. But as we’ll see below in the discussion of mutual fund shares, it’s not always that simple.
It also is important to note that individual securities of the same investment can have different cost bases depending on when the shares were purchased. For example, let’s say you purchased 10 shares of XYY Corp.* for $100 per share in January 2015 and then added to that position by purchasing 10 more shares of XYZ Corp. for $110 per share in March 2015. In July 2016, you decide to sell all 20 shares when XYZ Corp. is trading at $175 per share.
Let’s look at what your cost basis and capital gains would be for these shares:
Lot A: 10 shares purchased January 2015 for $100/share; sold July 2016 for $175/share
Cost basis = $100/share
Capital gain = ($175 – $100) = $75/share x 10 shares = $750
Lot B: 10 shares purchased March 2015 for $110/share; sold July 2016 for $175/share
Cost basis = $110/share
Capital gain = ($175 – $110) = $65/share x 10 shares = $650
This is why it is important to keep track of the purchase prices for your investments and think strategically about which specific shares you want to sell. At The Retirement Network, we closely track and monitor this information for our clients, but we still think it is important for our clients to understand the dynamics of how cost basis and capital gains work.
Cost Basis for Mutual Funds
Determining cost basis gets slightly more complicated with shares of mutual funds that pay a dividend or capital gains distribution. When dividends or distributions are reinvested in the mutual fund, the investor’s cost basis goes up by the amount of the dividend or distribution. This higher cost basis reduces the amount of capital gains tax owed when the investor sells the shares.
The reinvested dividends or distributions also impact the performance figure that gets reported on the investor’s monthly or quarterly statements. To learn more about how reinvested dividends or capital gains distributions affect the reported performance of a mutual fund, we recommend that you read Vanguard’s article on the topic: Cost Basis Doesn’t Equal Performance.
If you have any questions about the cost basis for your stocks, mutual funds, bonds, or other securities, please do not hesitate to contact us.
*XYZ Corp. and the stock information is purely fictional and for illustrative purposes only. This is not intended to resemble the performance of any actual company.
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