I recently had several clients who needed help sorting out their investment cost bases. It got me thinking - while “cost basis” is a common term to those of us working in the investment industry, those working outside of finance may not fully understand what it is and why it’s important.
So what is cost basis (or plural - bases) and why is it important to you?
Cost basis is essentially what you paid to purchase an investment. The difference between it and what you ultimately sell the investment for is considered your capital gain (or loss) and what you must pay taxes on. For an investment that you purchase one time, it’s easy to calculate – it’s simply the price you pay for the investment the day you purchase it (plus any transaction costs). It becomes more complicated if you then reinvest the dividends and/or capital gains from the investment and/or the investment goes through some sort of change such as a stock split or a merger with another company or mutual fund.
An easy way to think about cost basis with reinvested dividends/capital gains is to compare it to the purchase of a house. You purchase the house and that purchase price is your initial cost basis. But over the years, you make improvements to the house, “costing” you additional money. Those improvements at additional “cost” are like dividend reinvestments, adding to the overall “cost” of the house. The same is true for reinvested dividends – they add to the initial “cost,” or cost basis, of your stock.
Let me use one of my recent clients as an example. Mr. and Mrs. Jones, we’ll call them for this example, purchased 200 shares of Provident Bankshares stock at its initial public offering in December 1987. Their initial cost basis is 200 (# of shares) X $8.75 (price/share on that day) = $1,750. Easy, right? Well…not quite. Mr. and Mrs. Jones then reinvested the dividends from this stock for the next 29 years (and continue to do so today), making 29 (years) X 4 (quarterly dividends/year) = 116 additional purchases to the initial cost of the stock. Fortunately, Mr. & Mrs. Jones kept their stock statements for the past 29 years, so documenting the cost of those additional 116 dividend reinvestments, while tedious, was doable. After also adjusting for a stock split, six additional special stock dividend reinvestments, and the purchase of the company and its stock by M&T Bank in 2009, VOILA – we have their total cost basis of approximately $19,000.
It’s a good thing that we went through the exercise of calculating Mr. & Mrs. Jones’ cost basis because if they were to sell that stock today, they would receive about $40,000 for it. Without knowing the cost of their 116 dividend reinvestments, they may have thought they owed capital gains taxes on $38,250 (the $40,000 sale proceeds less the initial cost basis of $1,750), when in fact they would really only owe capital gains taxes on $21,000 (the $40,000 sales proceeds less the TOTAL cost basis of $19,000). That’s a tax savings of $2,587.50, assuming a 15% capital gains tax rate!
Now do you know the cost basis for all of your investments? While the government has mandated that brokerages and other investment firms must track this information beginning in 2011, 2012, 2014 and 2016 (the exact year depends upon the type of the investment), you may need to research the cost basis of any investment you’ve held prior to these years. I recommend you do this as soon as possible so that you don’t need to scramble after a sale at tax time to pull this information together.
If your cost basis is complicated, like the example above, I can help you get it organized. And…stay tuned for my article next month on 5 Ways to Handle Investments with Missing Cost Bases.