Cost basis is what you originally paid for an asset, adjusted for certain events like stock splits, reinvested dividends, and return of capital. When you sell, your capital gain or loss is the difference between the sale price and your cost basis. Getting your cost basis right is essential for accurate tax reporting — overstating your basis understates your gains (illegal), while understating it overstates your gains and costs you unnecessary tax dollars.
Multiple methods exist for calculating cost basis when you've purchased shares at different times and prices: FIFO (First In, First Out — oldest shares sold first, default method), specific identification (you choose which shares to sell, offering the most tax control), and average cost (total cost divided by total shares, common for mutual funds). You must elect your preferred method with your broker before selling — you cannot retroactively change it after a sale has occurred. Once established for an account, changing methods requires IRS-approved procedures.
Choosing the right cost basis method can significantly impact your tax bill. If you bought shares at $50, $75, and $100, selling the $100 shares first (highest cost basis) minimizes your capital gain. This is why specific identification is preferred by tax-savvy investors — it provides the most control over tax outcomes. Most brokerages now track cost basis automatically, but for assets purchased before 2011 (when mandatory broker tracking began), you may need records from your own purchase documentation.
Reinvested dividends are a commonly missed cost basis adjustment. When you hold a dividend-paying fund and dividends are automatically reinvested, each reinvestment creates a new tax lot with its own cost basis. Over years of DRIP investing, a position that started with $10,000 may have dozens of tax lots from reinvested dividends. Failing to include these reinvested dividends in your cost basis results in double taxation — you already paid tax on the dividend when received, and you'd be taxed again on it as a capital gain when you sell. Most brokerages track this automatically for shares purchased after 2011.
Stock splits and return of capital adjust your per-share cost basis. A 2-for-1 stock split doubles your share count and halves your per-share cost basis. If you paid $100/share and the stock splits 2-for-1, your new cost basis is $50/share. Return of capital distributions (common in REITs and MLPs) reduce your cost basis — if your basis is $50/share and you receive $2 of return of capital, your new basis is $48/share. Failing to track these adjustments creates inaccurate gain calculations.
The wash sale rule is a critical cost basis complication for tax-loss harvesters. If you sell a security at a loss and repurchase the "substantially identical" security within 30 days before or after the sale, the IRS disallows the loss for current-year tax purposes. The disallowed loss is not permanently lost — it's added to the cost basis of the repurchased shares. For example: sell 100 shares at a $1,000 loss, then buy them back 20 days later at $45/share. The $1,000 loss is added to the new cost basis: $4,500 repurchase + $1,000 disallowed loss = $5,500 adjusted basis. The wash sale rule applies across all accounts you own (including IRAs), so tax-loss harvesting must account for holdings across your entire household.
Inherited assets receive a "stepped-up" cost basis that eliminates embedded capital gains. When you inherit stocks, real estate, or other assets from a deceased person, your cost basis is "stepped up" to the fair market value on the date of death — not the original purchase price the deceased paid. If your grandmother bought Apple stock for $5/share and it was worth $180 when she passed, your inherited basis is $180. If you sell it for $185, you owe tax on only $5 of gain — despite the stock appreciating by $175 during her lifetime. This stepped-up basis is one of the most significant estate planning advantages for long-term investors and is the primary reason very wealthy families sometimes hold appreciated assets until death rather than selling.