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.

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. 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?

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?

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?

Death is an unfortunate part of life, but the IRS provides tax benefits for inherited securities. Two key rules apply:

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

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.

• With the step-up, the taxable gain is $100 per share ($1,100 sale price − $1,000 stepped-up basis).
• Without the step-up, the taxable gain would be $600 per share ($1,100 sale price − $500 original basis).

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

• 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, 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.

Gifted securities

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:

• The original owner’s cost basis
• The original owner’s holding period

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.

• 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 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

• 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

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:

• 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.

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:

• New purchase price = $30 per share
• Disallowed loss = $22 per share
• Adjusted cost basis = $30 + $22 = $52 per share

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:

• Convertible securities
• Rights
• Warrants
• Options

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:

• Coupon
• Maturity
• Issuer

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:

• Replacement shares cost basis = $76 + $17 = $93 per share

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.

Sidenote

Selling specific shares

When investors sell shares accumulated over several trades, deciding which shares are being sold affects the reported gain or loss. 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 using FIFO. In this example, they would be selling:

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

Now find the total cost of the 800 shares sold:

• 500 shares cost $10,000 in 2020
• 300 shares cost $7,500 (300 shares x $25 per share) in 2021

Total cost basis = $17,500 ($10,000 + $7,500), which is an average cost basis of:

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

When the investor sells at $30 per share, the gain is $8.12 per share ($30.00 sales proceeds - $21.88 cost basis).

The investor could also choose a last-in, first-out (LIFO) basis, which sells the newest shares first. Using the same sale (800 shares at $30 per share), LIFO would sell:

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

Now find the total cost of the 800 shares sold:

• 625 shares cost $10,000 in 2022
• 175 shares cost $4,375 (175 shares x $25 per share) in 2021

Total cost basis = $14,375 ($10,000 + $4,375), which is an average cost basis of:

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

When the investor sells at $30 per share, the gain is $12.03 per share ($30.00 sales proceeds - $17.97 cost basis).

Last, the investor can use specific share identification, where the investor identifies exactly which shares are being sold. To minimize taxes, the investor typically sells the highest-cost shares first. Using this method, they’ll sell:

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

Now find the total cost of the 800 shares sold:

• 400 shares cost $10,000 in 2021
• 400 shares cost $8,000 (400 shares x $20 per share) in 2020

Total cost basis = $18,000 ($10,000 + $8,000), which is an average cost basis of:

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

When the investor sells at $30 per share, the gain is 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 is the most tax efficient because it produces the lowest reported gain. Lower reported gains generally mean lower taxes.

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 uses a cost basis equal to the average cost 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.