What Is Cost Basis? (With Guide and Affecting Factors)
By Indeed Editorial Team
Updated June 10, 2022
Published January 3, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
With the stock markets becoming increasingly appealing and accessible to the public, it's essential for investing beginners to acquire sound knowledge of stocks and trading and for investment professionals to increase their trading vocabulary. The concept of cost basis is an important aspect regarding investors' and federal agencies' tax investments. Understanding this concept and its effects can help determine whether an investment is a gain or a loss. In this article, we explore the cost basis, explain how to calculate it, and find out what affects it.
Related: How to Improve Communication Skills
What does cost basis mean?
Cost basis, also called tax basis, is the initial amount paid while purchasing an asset in the stock market, mutual funds market, or the real estate industry. The investment's basis is typically the purchase price with a few adjustments to account for specific actions the company takes. These adjustments include stock splits, the distribution of dividends, wash sales, bankruptcies, mergers, and return of capital to shareholders. You usually need this amount to determine the profit made from the sale of an investment.
The profit, also called capital gain, is equal to the difference between the investment's initial purchase price and the current market value. If you buy a stock without using a direct purchase plan, the asset's basis can include broker's fees and commissions. When filing taxes under the Canadian Revenue Agency (CRA), it's your duty to report your basis accurately. You can also use the accurate basis calculation to note how profitable investments are to other investors.
How to calculate the tax basis of investments
Here are the steps you can use to calculate the tax basis for your tax or investment planning:
1. Establish the initial investment amount
The first step to calculating the tax basis of an investment is to document the original amount paid for the investment. In a case where the asset is a stock purchased a long time ago, you can find the accurate cost of the stock as long as you know the date of purchase. Multiple tools and websites are available to find historical Canadian stock prices for companies trading on the Toronto Stock Exchange (TSE).
Some of these tools have information on the everyday prices of stocks dating back to the early 90s. It's worth noting that the documentation of initial price for investments such as land purchase is more accessible, seeing as the vendor dispenses receipts.
2. Derive the per-share cost of the investment
It's essential to know the capital gains on a stock. The best way to calculate capital gains requires knowing the per-share cost of the stock. Since you generally buy and sell stocks in shares, you can derive the per-share price by dividing the original dollar amount invested by the number of shares the amount could purchase. For example, if you used $5,000 to purchase 20 shares of Green Follicles Incorporated, you can divide the original amount paid by the number of shares you purchased.
In this case, the calculation is:
5,000/20 = $250
This means the per-share cost of your investment is $250.
3. Include any commission paid during the purchase of the investment
Investors and the CRA regard the addition of the commissions paid during the purchase of the investment as critical, seeing as it's part of what you first paid for the investment. You may incur these commissions when you buy or sell stock through online brokers or the ones institutional investors incur when working with investment banks.
The commissions vary by broker, but they mostly charge them in flat rates, nominal rates per share, a percentage of the total trade value, or a combination.
4. Use an inventory costing method to determine the volume of your capital gains tax
One of the easily recognized inventories costing methods by the CRA is the first-in, first-out (FIFO) method. The FIFO method tracks the value of stocks as you purchase and sell them for your investment portfolio. The method concludes that any stock you're buying first is also the stock you record as the first sale when taking inventory, even if you didn't physically sell the stock first. This method can help you get a better capital gains tax.
For example, if you buy 500 shares of Blue Carton stock today at three dollars each and then buy another 500 the next day at seven dollars each, you may assign the cost of the first set of shares as resold at three dollars. Once you sell 500 shares, you may set the next 500 at the seven-dollar value, no matter the additional inventory purchased within that time.
5. Consider factors that may affect the initial purchase price
It's important to account for the possibility of corporate or financial developments that can affect the company in which you invested and ultimately affect your original investment price. This consideration is crucial to help you determine whether you made a capital gain. For example, if a merger takes place that involves a company in which you invested, you may require an adjustment to your tax basis if the number of stock you own changes.
Consider a situation where the merger results in you receiving two shares of the merged company for every one share you owned of the standalone company. You may determine the new tax basis for the number of shares you hold.
6. Report any payouts
Different investments pay in various methods, periods, and currency forms. You can expect the payout of some investments periodically, such as monthly or yearly, and some companies distribute earnings to investors through dividends, share buybacks or both. Regardless of how you receive your earnings, the CRA regards it as income and demands you report it.
Factors that can affect tax basis
Calculating your tax basis is a relatively short process as long as you always consider certain factors during the analysis. These are a few developments that can affect your calculations:
Wash sale rule
A wash sale rule states that if you sell a stock, bond or option at a loss and you buy that exact supply or a substantially identical stock within 30 days of the sale, you can't claim it for tax purposes. Brokers designed this rule to discourage people from selling their investments at a loss to claim tax benefits. If you undergo a wash sale, you may document it and ultimately adjust it in your tax reporting to the CRA.
Investors generally avoid wash sales by waiting 31 or more days before repurchasing the same investment.
A bankruptcy involving a company you have shares in can affect the shares on varying levels. Bankruptcies usually occur when an individual or business has comprehensively lost the ability to repay its outstanding debts. There are different types of bankruptcies a business can declare, and they have different effects on shares and, ultimately, your tax basis. If a company you invested in files for personal bankruptcy under the Bankruptcy and Insolvency Act of Canada (BIA), then the company may cease to exist, and take a toll on its shares.
The company may perform a Companies' Creditors Arrangement Act (CCAA) filing if it has excessive amounts of debt to creditors. This type of bankruptcy allows the company's stocks to retain a small amount of value and trade on an exchange platform. This type of bankruptcy allows the initial tax basis calculations to apply.
A stock split is a phenomenon that occurs when a company boosts its number of existing stocks by dividing each of them into two or more stocks. For instance, if a stock split takes place in a three-to-one ratio, the number of stocks triples while the price of each stock divides by three. This split doesn't change the initial amount of money spent on the stocks, but the cost per share becomes the share price after the stock split.
Capital improvements are the additions to an asset that can inflate the sale price of the investment. These additions are primarily permanent, and they guarantee enhancement of the investment's value, prolongation of usefulness, and adaptation to new purposes. You can use a simple formula to calculate the taxable amount on a property's capital gain. An excellent example of a capital improvement is when an investor purchases a home for $50,000 and spends an extra $10,000 to redo the bathrooms. The tax basis of the house undergoes a $10,000 increase.
If the owner decides to sell the home later on for $100,000, the taxable amount for the capital gain is $40,000. You add the initial purchase price and the capital improvement, then subtract from the sale price. The mathematical representation of this calculation is:
($100,000 - ($50,000 + $10,000)) = $40,000
Please note that none of the companies, institutions, or organizations mentioned in this article are affiliated with Indeed.
Explore more articles
- What Is ETL? (Definition, Process, Tips, and Benefits)
- What Is Private Equity? (A Definitive Guide)
- Guide to Rapid Application Development (Steps and Tips)
- Definitive Guide to Long-Term Assets (Including Examples)
- What Is a Burnup Chart? (With Steps for How to Create One)
- How to Proceed When Hiring Freelancers in 8 Actionable Steps
- What Is a Planogram? (With Steps, Benefits, and Tips)
- 10 Essential Tips for Effective E-Mail Communication
- What Is an Operating System? (Plus Functions and Types)
- Easy Certifications To Include On Your Resume (By Industry)
- What Is a Product Requirements Document? (And How to Write One)
- Understanding the Definition of Value Creation In a Company