Throughout this unit, we’ve discussed why cost basis matters for tax purposes. In most cases, cost basis is the total amount invested in a security, including transaction costs (such as commissions). In some situations, though, special rules require you to adjust cost basis. You’ll want to know when these adjustments apply and how to calculate them.
In the common stock chapter, we discussed how stock dividends pay investors more shares of stock. The number of shares owned increases while the price per share decreases. The cost basis adjustment follows the same logic as the position adjustment: the total dollar cost stays the same, but it’s spread across a different number of shares.
Let’s look at a practice question.
An investor purchases 100 shares of WMT stock at $125. Several months later, WMT issues a 25% stock dividend. What is the investor’s adjusted cost basis?
New cost basis = 125 shares at $100
The investor’s original position was 100 shares at $125 per share. Convert the stock dividend to a factor by adding the decimal form of the dividend (0.25) to 1:
Now adjust the position:
New shares = 100 shares x 1.25 = 125 shares
New price = $125 / 1.25 = $100 per share
Stock splits work the same way. If you need a full review, revisit the common stock section on stock splits and the adjustment process.
An investor purchases 500 shares of AAPL stock at $200. Several months later, AAPL performs a 4:1 forward stock split. What is the investor’s adjusted cost basis?
New cost basis = 2,000 shares at $50
The investor’s original position was 500 shares at $200 per share. Convert the split ratio to a factor by dividing the first number by the second:
Now adjust the position:
New shares = 500 shares x 4 = 2,000 shares
New price = $200 / 4 = $50 per share
Reverse stock splits use the same process, but the factor will be less than 1.
An investor purchases 200 shares of ZZZ stock at $4. Several months later, ZZZ performs a 1:5 reverse stock split. What is the investor’s adjusted cost basis?
New cost basis = 40 shares at $20
The investor’s original position was 200 shares at $4 per share. Convert the split ratio to a factor:
Now adjust the position:
New shares = 200 shares x 0.2 = 40 shares
New price = $4 / 0.2 = $20 per share
Death is an unfortunate part of life, but the IRS provides tax benefits for inherited securities. Two key rules apply:
When an investor dies, their assets pass to beneficiaries. The beneficiary’s new cost basis is the security’s value on the date of the original owner’s death. The beneficiary’s holding period is also treated as long-term, no matter how long the original owner held the investment.
An investor purchases 100 shares of ABC stock at $500 per share on January 10th, 2022. The investor dies on June 10th, 2022 when ABC was at $1,000 per share. The investor’s daughter sells the inherited shares at $1,100 on July 1st, 2022.
Even though the shares were purchased at $500, the cost basis is stepped up to $1,000 on the date of death. That step-up reduces the taxable gain.
The gain is also treated as long-term, even though the shares were held for roughly six months.
Assuming the inheritor is in the 32% tax bracket, here’s the difference in tax liability:
With inheritance tax rules
Without inheritance tax rules
As you can see, inheritance rules can significantly reduce tax liability. Instead of paying 32% on a $60,000 short-term gain, the inheritor pays 15% on a $10,000 long-term gain, for tax savings of $17,700.
This is a simplification for exam purposes; the actual rules when filing taxes are more complex.
Gifted securities don’t receive the same tax benefits as inherited securities. The recipient generally takes:
Using the same facts as the inheritance example (but treated as a gift):
An investor purchases 100 shares of ABC stock at $500 per share on January 10th, 2022. The investor gifts the shares to their daughter on June 10th, 2022 when ABC was at $1,000 per share. The daughter sells the shares at $1,100 on July 1st, 2022.
In this case, the daughter keeps the original $500 cost basis and the short-term holding period.
A wash sale occurs when an investor sells a security at a loss and repurchases it within 30 days of the sale. The rule is designed to prevent an investor from claiming a deductible capital loss while quickly re-establishing essentially the same position.
For example:
January 20
March 15
March 16
The investor sold at a loss and repurchased the next day. Economically, they’re back in the same position, but they would also have a deductible $3,000 loss. The IRS disallows that loss under the wash sale rule.
The basics of the rule are:
Let’s run through an example:
An investor purchases 100 shares of MNO Fund at $50 per share on February 10th. On April 20th, the shares are sold for $28 per share. On May 5th, the investor buys 100 shares of MNO Fund at $30.
On April 20th, the investor realizes a $22 per share loss ($50 − $28), or $2,200 total. Because the investor repurchases within 30 days (15 days later), the $22 per share loss is disallowed and can’t be used as a current tax deduction.
The loss doesn’t disappear, though. It’s added to the cost basis of the new shares:
If the investor later sells at $30, they would then have a $22 per share loss ($30 sales proceeds vs. $52 cost basis). If they sell and do not repurchase again within 30 days, that loss can be recognized.
The wash sale rule applies when repurchasing the same security, and it can also apply to a similar security. The IRS calls these “substantially identical securities.” For stock, this includes:
If a security provides a straightforward way to obtain the stock (by converting or exercising), it’s treated like buying the stock itself.
For bond wash sales, the standard is different. If an investor repurchases a bond within 30 days of selling a bond at a loss, they can avoid the wash sale rule if two of the following three items on the new bond are different:
The 30-day window applies both before and after the loss sale. This prevents investors from buying shares shortly before selling at a loss (sometimes called “front-loading”). For example:
An investor purchases 100 shares of AXP stock at $90 per share on August 20th. On October 1st, 100 more shares of AXP are purchased at $76. The next day, the stock is sold for $73 per share.
Assuming FIFO (see below), the investor sells the original 100 shares on October 2nd for a $17 per share loss ($73 − $90). Because the investor bought 100 shares the day before (within the 30-day window), the $17 loss is disallowed and added to the cost basis of the replacement shares:
If the investor later sells those shares, any loss can be recognized as long as they don’t repurchase again within 30 days of that later sale.
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