Understanding Covered Cost Basis

October 28th, 2020

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All your investments – real estate, stocks, mutual funds have taxes associated with them.

You need to be aware of all the tax implications associated with different types of investments to make sure your investment returns can be maximized.

Cost basis is a significant aspect that helps to understand how investments are taxed.

This article will help you understand cost basis and specifically covered cost basis, which can have important implications for your tax returns and eventual tax payments.

What is Cost Basis?

Simply put, the cost basis is the purchase price of your investment. It is the total amount originally invested to purchase an asset or stock, plus any commissions or fees. Cost basis is used to report your assets on your taxes and to determine capital gains or losses. It helps to better understand how profitable investments are for investors.

How to Calculate Cost Basis?

Determining the cost basis for a single stock would simply be the original purchase price of the stock. However, during the lifetime of investments, a stock can go through several stages – buying more stock, dividends, stock splits, and return of capital. In such cases, it is important to learn how to calculate cost basis.

1. Determine the original purchase price: When calculating the cost basis for your taxes, start by documenting the purchase price paid the first time you invested. For example, if you bought 100 shares of company XYZ at $20, your cost basis is $20.

2. Don’t forget any commissions: It is important to remember to include any commissions or fees you paid when you purchased the stock. It is part of the purchase price and is required to estimate the cost basis.

3. Timing your investment: The capital gains or losses are based on the duration or time you held your position. One such method is the first in first out (FIFO) calculation, which translates to the first investments bought are the first investments to be sold. There will be a higher capital gains tax for selling shares that were bought earlier.

4. Reporting dividends: Many companies offer yearly or quarterly dividends and whether you receive them as cash or reinvest these dividends, these dividend earnings must be reported as income earned.

5. Stock Splits: What would the cost basis be when there is a 2-for-1 stock split? Using the previous example of buying 100 shares of XYZ company at $20. After the stock split, you now have 200 shares at $10 each. Your cost basis changes to $10 per share.

Example of Cost Basis

Let us say you invested $5,000 to purchase 500 stocks of company ABC and paid a trading fee of $10. Later, ABC split the stocks 2-for-1. A year later, the company stock price increased to $8 and you decided to sell your investment.

Initial Cost Basis = $10,After stock split, cost basis = $5; total number of shares = 1000,Sell 1000 shares at $8 per share.

Cost basis for 1000 shares  = $5,000 and Sale Price = $8,000

Total capital gains to be reported = 8000 – 5000 = $3,000

What is Covered Cost Basis?

A covered cost basis means that your brokerage firm is responsible for reporting the cost basis and sale price of your assets to the IRS. If you transfer your account to another broker or firm, the previous firm is required to send this information with your account.

Conversely, a noncovered cost basis means that you are responsible for reporting the cost basis to the IRS and your brokerage is only responsible for providing any sale information.

What happens if you forget to report your cost basis to the IRS?

In case you forget to report your cost basis, the IRS will consider your assets to have been sold at a 100% capital gain, resulting in a higher tax liability.

If you purchased stock before January 1, 2011, these securities are considered noncovered. Any mutual funds bought before January 1, 2012, are also considered noncovered. Any investments made after the above dates are most likely covered.

Where can I find cost basis information?

Covered cost basis information can be found on tax form 1099-B. It will be provided to both the shareholder as well as the IRS.

Why is recording Cost Basis Important?

Having an organized record of your investments and determining your cost basis is essential for several reasons:

1. Estimate your Short-Term Tax Rate: The tax rate associated with short-term capital gains (investments held for less than a year) can be higher and it can significantly affect your financial plan. If you do not keep track of your purchase price and date, you may end up paying higher taxes than intended.

2. Estimate your Long-Term Tax Rate: Taxes associated with long term capital gains (investments held for over a year) are typically lower and the amount of tax you pay is dependent on your income level. For long term value investors, avoiding or lowering capital gains tax is a strategy to build wealth by reinvesting saved tax dollars.

3. Data Analytics: Having a complete record of your cost basis helps to assess your investment choices and provide a clear snapshot for failed investments. Data analytics can help you make the correct choices and build an investment strategy well-suited to your financial goals.

Different Covered Cost Basis Methods

Mutual funds and brokerage firms are responsible for reporting gains or losses when an investor sells their securities. These companies are required to report the method used to calculate the cost basis. Typically, companies use the average cost method for individual stocks and the FIFO method for mutual funds. Here is a list of several methods that can be used.

Average Cost (AC)

This method uses an average value to compute the cost basis for all transactions in the account. For example, if you bought 100 shares at $10 and later bought another 100 shares at $15, your cost basis will be the average - $12.5 for 200 shares.

First In First Out (FIFO)

This method relies on a strategy where the oldest shares purchased are the first shares sold to determine the tax basis and holding period.

Last In First Out (LIFO)

The most recent shares purchased are treated as the first shares sold to determine the tax basis and holding period of the shares sold.

High Cost First Out (HIFO)

Sell the most expensive shares in the account first.

Low Cost First Out (LOFO)

Sell the least expensive shares in the account first.

Specific Lot Identification (SLID)

Shareholders will designate which specific shares to redeem when placing their redemption request.

Loss/Gain Utilization (LGUT)

This method estimates the losses and gains and strategically selects lots based on gains/losses in conjunction with the holding period.

In conclusion, having complete information about your cost basis for all your investments can help you plan your taxes and devises an investment strategy to maximize gains.

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