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Understanding Cost Basis: A Guide by O1ne Mortgage

When you sell an investment or a home, you may face capital gains taxes. The cost basis, which is the original price you paid for the asset, plays a crucial role in determining your tax liabilities. Understanding how cost basis works can help you estimate your tax obligations when you’re ready to sell.

What Is Cost Basis?

Cost basis is the amount you initially paid for your investment. For stocks, this includes the price per share at the time of purchase, plus brokerage fees and other costs. For mutual funds, it also includes any upfront load fees. When it comes to real estate, your cost basis includes the original purchase price, major home improvements, and casualty and theft losses.

When you sell an investment or a home, you may be subject to capital gains tax. To determine your gain or loss, you’ll use the sale proceeds and cost basis, which will then help calculate your capital gains tax bill.

Cost Basis vs. Market Value

While cost basis is the original price you paid for an investment, market value is the current price at which you could sell it. Understanding the market value of your asset can help you estimate potential tax consequences if you decide to sell.

How to Calculate Cost Basis

The process for calculating cost basis varies between investment securities and real estate. Here’s a quick overview:

Cost Basis for Investments

There are several methods to calculate the cost basis of your investment portfolio:

• First-in, first-out (FIFO): This default method assumes that the oldest shares are sold first. If your first shares had a lower price, this could result in a higher gain and a bigger tax bill.
• Specific identification: You can choose which shares to sell based on their cost basis. By selecting shares with a higher purchase price, you can minimize your realized gain and reduce your tax liability.
• Average cost, single category: For mutual funds, this method averages the cost of all shares and multiplies it by the number of shares sold.

Cost Basis for a Home

To calculate the cost basis for real estate, add the following costs:

• Original purchase price
• Eligible settlement fees and closing costs
• Major home improvements
• Costs to repair damage

Then, subtract certain expenses such as allowable depreciation for business or rental purposes, casualty losses, insurance payments for casualty losses, and energy credits and subsidies.

The IRS provides an exclusion for capital gains tax for taxpayers who have lived in the home for at least two out of the previous five years. You may be able to exclude up to $250,000 in capital gains ($500,000 if married and filing jointly).

Examples of Cost Basis

Here are some examples to illustrate how you might calculate the cost basis:

FIFO Method vs. Specific Identification Method

Suppose you purchased shares of ABC company as follows:

• 10 shares at $10 per share
• 15 shares at $12 per share
• 5 shares at $14 per share

If the price rises to $20 and you sell 5 shares, you’d get $100. Using the FIFO method, your cost basis would be $50 (5 shares at $10), resulting in a gain of $50. With the specific identification method, you could sell the 5 shares bought at $14, giving you a cost basis of $70 and a taxable gain of $30.

Average Cost, Single Category Method

Suppose you bought 100 shares of a mutual fund at an average cost of $65 per share. If you sell 20 shares at $75 per share for $1,500, your cost basis would be $1,300 (20 shares at $65), resulting in a taxable gain of $200.

Real Estate Method

Suppose you bought a home for $200,000 and sold it for $300,000 after several years. You invested $20,000 in improvements and received $5,000 in insurance payouts for losses. To calculate your cost basis, add the $200,000 purchase price and $20,000 in improvements, then subtract $5,000, resulting in a total of $215,000. Your gain would be $85,000, which is below the exclusion amount if you lived in the home for at least two out of the past five years.

Frequently Asked Questions

• Why Is Cost Basis Important?
• How Do I Determine the Cost Basis of Gifted Stock?
• What Can Be Included in the Cost Basis of Property?

The Bottom Line

Managing taxes on an investment portfolio or a home sale can be complex. Understanding how to calculate your cost basis and gain can help you estimate your tax bill. If you’re overwhelmed by the process, consult with a tax professional for personalized guidance.

For any mortgage-related needs, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial journey with confidence.

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