Cost basis adjustments

Throughout this unit, we’ve discussed the importance of cost basis for tax purposes. In most situations, it represents the overall amount invested in a security including transaction costs (e.g., commissions). However, there are some circumstances where unique cost basis adjustments occur. It’s essential to understand when they occur and how the adjustment is made.

Stock dividends and splits

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. If you remember the adjustment to the investor’s stock position, you already know how to make the cost basis adjustment (it works the same way). If not, click the link above to refresh yourself on the process.

Let’s look at a practice question to test your knowledge.

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?

Stock splits work the same way. Again, visit the common stock section on stock splits if you need to thoroughly review 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?

Reverse stock splits work the same way, but in reverse:

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?

Death is an unfortunate aspect of life, but the IRS attempts to make the grieving process easier by reducing tax burdens on inherited securities. In particular, two tax-beneficial things occur:

• Cost basis is “stepped up”
• The holding period is automatically long-term

When an investor dies, their assets are passed on to their beneficiaries. The new cost basis of the security reflects the value on the day of the original owner’s death. Also, the holding period for the inheritor is long-term, regardless of how long the original owner held the investment. To better understand this, let’s assume the following:

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.

Although the 100 shares were originally purchased at $500, the cost basis is “stepped up” to $1,000 when upon the original owner’s death. The step up reduces taxation considerably. The investor locks in a taxable gain of $100 per share with the step-up ($1,000 cost basis vs. $1,100 sales proceeds). If the step-up didn’t occur, the inheritor would’ve reported a $600 taxable gain per share ($500 cost basis vs. $1,100 sales proceeds). Additionally, the gain is long-term, although the shares were only held for roughly six months.

Assuming the inheritor is in the 32% tax bracket, let’s look at the difference in tax liability:

With inheritance tax rules

• Cost basis = $1,000 per share
• Sales proceeds = $1,100 per share
• $100 taxable gain per share
• $100 gain x 100 shares = $10,000 overall gain
• $10,000 gain x 15% (long term gain rate) = $1,500 tax liability

Without inheritance tax rules

• Cost basis = $500 per share
• Sales proceeds = $1,100 per share
• $600 taxable gain per share
• $600 gain x 100 shares = $60,000 overall gain
• $60,000 gain x 32% (short term gain rate) = $19,200 tax liability

As you can see, the inheritance tax rules can significantly reduce tax liability. Instead of paying a 32% tax (tax bracket applies to short-term gains) on a $60,000 gain, the inheritor only pays a 15% tax on a $10,000 gain, resulting in tax savings of $17,700.

Gifted securities

This is a simplification for exam purposes; the actual rules when filing taxes are more complex.

Unlike inherited securities, gifted securities are not eligible for tax benefits. The original owner’s cost basis transfers directly to the person receiving the securities. Additionally, the holding period does not adjust. To better understand this, let’s use the same example from above (adjusted to be 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 retains the original cost basis of $500 and short-term holding period.

• Cost basis = $500 per share
• Sales proceeds = $1,100 per share
• $600 taxable gain per share
• $600 gain x 100 shares = $60,000 overall gain
• $60,000 gain x 32% (short term gain rate) = $19,200 tax liability

Wash sales

A wash sale occurs if an investor sells a security at a loss and repurchases it within 30 days of the original sale. This rule prevents investors from selling investments to lock in a deductible capital loss, only to repurchase it immediately or quickly after. For example:

January 20

• Investor purchases 100 shares at $50

March 15

• Investor sells 100 shares at $20
• Realized loss of $30 per share ($3,000 overall)

March 16

• Investor buys 100 shares at $20

Although the investor sold their shares at a loss, they repurchased the shares the next day. Nothing significant occurred except for the $3,000 realized loss, which is deductible. The IRS feels this encourages investors to sell securities at a loss and repurchase them to obtain tax benefits. To prevent it from commonly occurring, the wash sale rule was created and imposed on security transactions. The basics of the rule are:

• Capital losses are disallowed if security is repurchased within 30 days of the sale
• Disallowed loss is added to the cost basis of the new position

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.

In this example, the investor locks in a $22 per share loss on April 20th, resulting in an overall $2,200 deductible capital loss. 15 days later, the investment is repurchased for $30 per share. The $22 per share loss is disallowed and cannot be used for a tax deduction.

The loss doesn’t completely evaporate, though. The disallowed loss is added to the cost basis of the new position, which helps reduce potential taxes when the investment is sold again. Although 100 new shares were purchased at $30, the investor will reflect a cost basis of 100 shares at $52 per share ($30 + $22 disallowed loss). If the investor were to sell their shares at the $30, they would reflect a $22 per share loss ($30 sales proceeds vs. $52 cost basis). If the investor doesn’t repurchase the shares again within 30 days, they can keep the $22 per share loss.

The wash sale rule applies to repurchases of the same security, or even a similar security. The IRS refers to these as “substantially identical securities.” For stock, this includes:

• Convertible securities
• Rights
• Warrants
• Options

If a security provides an easy way to obtain the stock (through converting or exercising), it’s considered the same as buying the actual stock. For bond wash sales, it’s a bit 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:

• Coupon
• Maturity
• Issuer

The 30-day period for wash sales applies both before and after the loss is realized. This prevents investors from “front-loading” shares. 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.

Before selling their shares at a loss, the investor purchased an additional 100 shares. On October 2nd, they sell the original 100 shares (assuming FIFO; see below for additional information on FIFO) for a $17 loss ($73 sales proceeds vs. $90 cost basis). Additional shares were purchased the previous day, within the 30-day wash sale period. Therefore, the $17 loss is disallowed and added to the cost basis of the current position. The investor now reflects a $93 per share cost basis ($76 cost basis + $17 disallowed loss). If they sell these shares later, they can keep any realized loss as long as they do not repurchase the shares again within 30 days of the sale.

Sidenote

Selling specific shares

When investors sell shares accumulated over several trades, deciding which shares to sell becomes an important objective. Let’s assume an investor purchases $10,000 of the fund each year over a 3-year period, all at different prices per share (known as dollar cost averaging).

Year	Purchase amount	Price per share	Shares purchased
2020	$10,000	$20	500
2021	$10,000	$25	400
2022	$10,000	$16	625

Unless otherwise specified, shares are sold on a first-in, first-out (FIFO) basis as a default, meaning the oldest shares are sold first. Let’s assume the investor sells 800 of their 1,525 shares at $30 per share and uses this method. In this example, they would be selling:

• 500 shares purchased at $20/share
• 300 shares purchased at $25/share

Next, the investor can find their overall cost basis by adding up the numbers. They bought 500 shares for $10,000 in 2020 and 300 shares for $7,500 (300 shares x $25 per share) in 2021. The total cost of the 800 shares (500 + 300) was $17,500 ($10,000 + $7,500). This adds up to an average cost basis of:

• 800 shares purchased at $21.88 ($17,500 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $8.12 per share gain ($30.00 sales proceeds - $21.88 cost basis).

The investor could also opt to sell shares on a last-in, first-out (LIFO) basis, which would sell the newest shares first. Again, let’s assume the investor sells 800 shares at $30 per share and find the overall gain using this method:

• 625 shares purchased at $16/share
• 175 shares purchased at $25/share

Let’s find their average cost basis. They bought 625 shares for $10,000 in 2022 and 175 shares for $4,375 (175 shares x $25 per share) in 2021. The total cost of the 800 shares (625 + 175) was $14,375 ($10,000 + $4,375). This adds up to an average cost basis of:

• 800 shares purchased at $17.97 ($14,375 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall $12.03 per share gain ($30.00 sales proceeds - $17.97 cost basis).

Last, the investor can also utilize a method called specific share identification, where the investor specifically identifies which shares to sell. To minimize taxes as much as possible, the investor will first sell the most expensive shares. Using this method, they’ll sell:

• 400 shares purchased at $25/share
• 400 shares purchased at $20/share

Let’s find their average cost basis. They bought 400 shares for $10,000 in 2021 and 400 shares for $8,000 (400 shares x $20 per share) in 2020. The total cost of the 800 shares (400 + 400) was $18,000 ($10,000 + $8,000). This adds up to an average cost basis of:

• 800 shares purchased at $22.50 ($18,000 / 800 shares)

When the investor sells those shares at $30 per share, they lock in an overall 7.50 per share gain ($30.00 sales proceeds - $22.50 cost basis). Let’s compare all of the numbers now:

Method	Gain per share
FIFO	$8.12
LIFO	$12.03
Specific share	$7.50

Of the three methods, specific share identification was the most tax efficient. Remember, the lower the reported gain, the less taxes the investor pays. Specific shares identification always allows investors to reduce their tax liability to the lowest possible level.

There is one additional method of determining what shares are sold, but it is only available to mutual funds (not stocks or other securities). Known as average cost, single category (ACSC), this method reflects a cost basis equal to the average of all shares purchased. Using the first table of this sidenote (above), the investor purchased 1,525 shares for a total of $30,000, resulting in an average cost of $19.67 ($30,000 / 1,525 shares).

Investors opting for ACSC are “locked in” after the first reported transaction. While investors are typically free to switch sales reporting methods (e.g. going from FIFO to LIFO), once ACSC is elected, it must be used until the position is completely liquidated.

Key points

Cost basis for stock dividends & splits

• Same method as making position adjustments

Inherited securities

• Cost basis is stepped up to the value on the date of death
• Holding period is always long term

Gifted securities

• Security retains the original cost basis and holding period when gifted

Wash sales

• Losses disallowed security is repurchased within 30 days of sale
• Disallowed loss added to cost basis of current position
• Applies to stocks if purchasing substantially identical securities:
  • Convertible securities
  • Rights
  • Warrants
  • Options
• Bonds avoid rule if the new bond has 2 of 3 items different:
  • Coupon
  • Maturity
  • Issuer

Selling security shares or units

• Investors can utilize FIFO, LIFO, or specific share identification
• Specific share identification results in the lowest tax liability

Average cost, single category

• Shares reflect the average cost for tax reporting
• Only available to mutual funds
• Investors “locked in” to this method once utilized