Almost all securities sales conclude with the seller either making or losing money on the transaction. Determining that profit or loss means the investor – or their tax professional – will need to know their basis in the assets, usually the amount initially invested in the security.
Unfortunately, many investors do a poor job of tracking their basis in securities investments and leave themselves and their tax preparers scrambling to find the necessary information at the same time they are preparing the investor’s taxes. That makes the months following the annual income tax filing deadline a great time for tax preparers to remind their clients to collect the information necessary to track their basis in investments going forward. This will both assist with future tax reporting and allow gains and losses to be more easily tracked.
Required basis reporting
Since 2012, brokerage firms have been required to track the adjusted basis of their client’s publicly traded securities. However, there are situations where those brokerage statements will not properly reflect the taxpayer’s basis in an investment. For example, if the taxpayer moved between brokers or has chosen to invest in non-publicly traded securities, their brokers’ statements may not provide a correct accounting of their basis.
Calculating cost basis
The starting point for calculating an investor’s cost basis in a security for tax purposes is usually the asset’s original cost. While this is a straightforward concept, certain events could change their cost basis. For example, a two-for-one stock split will reduce the investor’s basis by half. The fees associated with selling the security may also be included in the basis. Finally, automatically reinvested dividends can increase a taxpayer’s basis in securities.
A common issue faced by investors when calculating the gain or loss on the sale of an investment is when the sale involves securities that were purchased at different times for different amounts. In these situations, there are three primary methods for calculating the basis for the shares sold:
First-in-first-out (FIFO) method. This is usually the default method for calculating the basis of securities sold because it is usually the easiest. Under the FIFO method, it is assumed that the oldest securities are sold first, and it is assumed all of those shares are sold before the basis of more recently purchased securities is used.
Average cost basis method. Using this method allows the taxpayer to use the average purchase price for all of the securities they hold at the time of the sale to determine their basis in the securities.
Specific shares method. This is often the most complicated method of determining the basis of securities purchased in multiple transactions. It requires the taxpayer to provide the broker with instructions on which specific shares to be sold and maintaining detailed records of those sales. However, the specific shares method gives the seller more control over how their basis is calculated.
While it can be time-consuming for a taxpayer to track their basis in their securities investment, those records will be necessary if the IRS questions their basis calculations. If neither the taxpayer nor the IRS can come up with a satisfactory cost basis for securities that have been sold, the agency will assume the basis is zero and the entire amount received will be treated as taxable gains. This also means that it will be impossible to claim a loss on a sale because the taxpayer will have no basis.
For more information on calculating basis and capital gains and losses for securities and other capital assets, check out our introduction to Schedule D (Form 1040), Capital Gains and Losses, self-study. The self-study is free to NATP’s premium members.