Cost Basis For Investments: Definition, Formula And Example
By Indeed Editorial Team
Published 19 October 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.
One key goal of investors and financial managers is to earn the maximum profit from an investment, which might mean purchasing an investment at a low cost and selling it at a high one. Investors who make money from their assets record the profits they make from these transactions for taxation purposes. If you are an investor or a financial professional, learning about different ways to measure the value of an investment, like cost basis, can help you manage your finances or advise your clients.
In this article, we define cost basis, explain why this value is important, describe some factors that affect this amount and show you how to calculate this value with a formula and example:
What Is Cost Basis?
Cost basis is the original monetary amount an investor provided to purchase an asset, like a group of shares, a piece of property or a building. Depending on the type of investment you have, you might record this amount as a total sum or divide it into parts to account for multiple shares. Investors use this value to calculate capital gains and losses for taxation purposes and to evaluate the overall health of an investment.
Why Is This Value Important?
Here are some reasons it is valuable to know this value for each investment you own:
Capital gains or losses
When you sell an investment, you record the amount you made or lost from the transaction, which is the capital gain or loss on the investment. To calculate capital gains or losses, you use the cost of the investment, which represents the original amount of money you or the original holder paid for the investment. While you might have recorded the original cost of the investment if you made the purchase yourself, if you inherited the investment or received it as a gift, you may do some research to identify the cost.
One of the most important reasons for accurate cost evaluation is to ensure that you or your client pays the proper amount of capital gains tax. The first step to filing taxes for investors is to identify the original cost of an investment. If you lost money when you sold an investment, you might be able to use that information to lower your tax amount, depending on the type of asset. Investors who sold assets for a profit pay taxes on the gain they made according to the original value.
Knowing how much you originally paid for an investment can help you evaluate its performance once you have owned it for years or even decades. While investments often lose and gain value over time, an investment that tends to lose more than it gains might not be a sound use of your money. After analysing the original value of the investment, you might choose to sell or liquidate the asset and reinvest the money.
What Factors Affect This Value?
Here are some factors that can affect this value:
An asset's acquisition method is the way you got the asset. You might have paid cash for the investment or traded another asset for it. Sometimes, investors acquire assets from a trust or fund. They might also inherit the asset from a family member or friend. The way you acquired the asset can affect the amount it costs to you. For example, if you bought an asset, this value is the amount you originally paid for it, whereas if you inherited it, its cost is the market value of the investment at the time of the donor's death.
Sometimes, companies change their shareholding model, which can affect the value of your investment. One change is called a stock split. For example, you might purchase stock in a growing company. As the company expands, the purchase price per share might increase beyond the ability of many investors to purchase the stock. The company might choose to split the stock, which doubles the number of existing shares and halves the price of each share. While a stock split does not affect the overall amount you paid for your shares, it does affect the per-share value.
If you own a tangible asset, like a house or boat, you might make improvements that increase the market value of it. For example, you might purchase a small vacation home on a lake for a certain price. After a few years, you might pay a contractor to add a deck overlooking the water. This addition can increase the value of the building. Because these values may be difficult to calculate, you might hire a professional appraiser to help you update the value of your asset in your records.
While some assets gain value over time, others, like cars and heavy equipment, depreciate or lose value the longer you own them. They may lose their value because of heavy use or because advances in technology have produced more efficient models. For example, if you buy a combine harvester to use on a farm, that asset might lose value as you use it and as more advanced harvesters enter the market. You can record depreciation on the capital gains or losses report you submit for taxation.
How To Calculate This Value In 5 Steps?
Here are five steps you can take to identify the cost value of an investment:
1. Determine how much you paid for the asset
Look through your financial records to find out how much money you originally paid for a specific investment. If you inherited the asset, you might ask the original holder's financial manager for the value at the time they gave it to you. For example, if you inherited 100 shares in a company from a deceased relative, you use the market value of the asset at the time the relative stopped owning it.
2. Identify the per-share value if applicable
For some assets, you might have a single value. For example, the value of a piece of property might be a single number. Other assets, like stocks, might have a total value and a per-share value. You can find this value by dividing the total amount paid by the number of shares. For example, if you paid ₹79,000 for 100 shares of a company, the per-share value is ₹790.
3. Add commission
You may have paid a commission to a broker or financial advisor when you purchased an investment. For example, many mutual funds have fees or commission amounts added to the value of the investment. If you paid any additional money to facilitate your purchase of an asset, add that to the amount you paid initially. You can divide this amount by the number of shares you have if the asset involves multiple shares.
4. Identify any external factors that might affect value
Next, assess the investment to account for any external factors that might affect its value. For example, if the asset is a home that you have improved, you can find the value increase by adding the cost of the improvements to the amount you spent to acquire it or by hiring a professional assessor to evaluate the property. If you purchased shares in a company that later engaged in stock splitting, you might adjust your per-share value if you plan on selling some, but not all, of your shares.
5. Use this value in reporting
Once you have accounted for any factors affecting investment value, the result is the cost basis of the investment. You can use this value for a variety of financial processes, including finding capital gains. To find capital gains on an investment you sold, you subtract the cost from the sales value of the investment. If you only sold some shares in a stock you own, use the per-share value for this calculation.
Example Of This Calculation
Here is an example of this calculation for an investor who has shares in a company:
Several years ago, an investor paid ₹40,000 to purchase 10 shares in a growing software company. Upon purchase, the value of each share was ₹4,000. As the company expanded, the leadership team wanted to make shares more financially accessible to employees and their families. The company performed a stock split to lower the cost of each share without allocating a larger portion of the business to investors. Now, the investor owns 20 shares with a value of ₹2,000 each.
The investor decides to sell 10 of those shares for ₹30,000 when their value is high. Because the original value of these 10 shares was ₹2,000 each, their total original value or cost basis, was ₹20,000. To find the capital gain, the investor can subtract this value from the sale price for a difference of ₹10,000.
Explore more articles
- Emotional Intelligence Skills (Definition And Examples)
- What Is Frame Rate? A Comprehensive Guide With Tips
- 14 Tips To Improve Presentation Skills (With Importance)
- A Complete Guide On Daily Scrum: Meaning, Steps And Tips
- 11 eLearning Tools To Assist With Workplace Training
- What Are Data Ingestion Tools? (With Best Practices)
- What Are Social Sciences? (Branches And Popular Job Roles)
- ITSM Vs. ITIL: What Are The Prominent Differences?
- What Is Business Integrity? (With Importance And Principles)
- 13 Interior Design Skills: Definition, Examples And Duties
- Athletic Trainer Skills: Definition, Examples And Tips
- What Is Cultural Intelligence? (Components And Importance)