The cost basis is the original amount paid for a given asset. Along with the basic purchase price, a cost basis will also account for any commissions or fees that were also incurred by the buyer as part of the process to complete the purchase. Knowing this figure is helpful in determining the amount of gains or losses that are made with the holding upon completion of the purchase.
It is important to note that the cost basis is focused on how much the holder of the asset had to pay in order to complete the acquisition, not the actual value of the asset itself. For example, it is possible for an investor to purchase a piece of real estate for more than the current appraised value of the home. This may occur because the investor has some reason to believe the property will eventually appreciate in value above the total acquisition cost, making the capital loss a short-term issue.
The same is true with stock offerings. An investor may become aware of stocks that are currently performing below par and choose to purchase them while they are in decline. This strategy is often employed when various market indicators point to a resurgence of the stocks at a later date. The investor quietly acquires the shares at a price that may be slightly above the current market value and holds them in anticipation of the expected turnaround. While there may be some degree of capital loss due to the purchase price and the continued low performance of the stock issues, this loss becomes a capital gain if the projections hold true and the stock rises above the original purchase price.
Understanding the cost basis provides a platform for evaluating the equities associated with assets. This in turn can also assist the investor in preparing accurate tax returns and paying the appropriate amount of taxes associated with the investments. As long as the asset is generating a capital loss, it is possible to claim all or a portion of the loss as a deduction on the tax return. Once the asset is generating a return that results in capital gains, this can also be reported accurately on the return, making it possible to calculate the amount of taxes due on that return.
While the cost basis is most commonly associated with the acquisition price of the asset, there are exceptions. One notable exception is when real estate or other holdings are acquired as an inheritance. Since no actual purchase was made, the cost basis in this scenario is usually the appraisal value of the assets at the time of the benefactor’s death. However, the exact regulations governing the calculation of a cost basis may vary somewhat according to circumstances and the laws in place locally. For this reason, it is always a good idea to consult a tax attorney or advisor if there are extenuating circumstances associated with the acquisition.