Wisdom Wealth Strategies Logo

Basis – Why it’s so important

Get the latest expert financial tips and advice + access to our free financial checklists.

IRS Lovo

The concept of basis has a huge influence on many tax rules. Basis is essentially the monetary value (or cost) that was paid for property, including investments, physical property, or collectibles. When an investment is sold, the gain or loss is dependent upon the basis, and is determined by calculating the selling price plus fees, minus basis. Because it sounds simple, many people don’t give it as much attention as it deserves.

Basis has many intricacies and can get mixed up in a variety of ways. One common example is that of a mutual fund or a stock investment with an automatic dividend reinvestment plan. Since the investment is paying taxable dividends that are reinvested, the original basis of the investment is adjusted.

For example, a $10,000 initial purchase of a mutual fund that reinvests $1,000 a year for five years will have a $15,000 basis. If the investor sells the fund for $14,000, they will claim a $1,000 loss, not a $4,000 gain.

The example above is straight-forward, but it can get more complicated. If multiple purchases are made at different prices, and then multiple sells are made at different prices, then what is the basis? With mutual funds, the investor can choose to their method of basis accounting, such as taking the average cost per share or selling specifically identified shares. The basis election can only be made once for the investment. I.E., once the investor chooses the average basis method, he or she is stuck with that accounting style for the remainder of time the investment is held.

For stocks, investors must identify specific shares in their transactions. If the basis cannot be identified, the taxpayer is deemed to have sold the oldest shares first. For example, an investor bought ABC stock at $10, $12, $15, and $20, in that order as the stock price was rising. If he or she cannot identify which shares were later sold in a partial sale, then the $10 shares are considered to be sold first.

Another common asset that needs to have its basis tracked is real estate. Whether a primary residence or a rental, both can have complex rules that adjust the basis, and thus potentially add or subtract to the tax bill in the future. As a general rule, improvements to a home, such as a remodeled kitchen, add to the basis of the home, while general repairs and maintenance, such as fixing a few shingles on the roof, do not.

The examples and descriptions above were very simple examples of basis with commonly held property. Basis can get much more complicated when gifting investments, inheriting investments, or depreciating rental property is involved. The good news is that brokerage accounts now have to report basis, but there are still plenty of times when an adjustment needs to be made, so it’s ultimately up to you to keep good records. Make sure you have a system for tracking basis, because if you don’t know what it is, the IRS will assume it is zero, which generates the largest tax bill. We’re sure you don’t want that to happen!

Download our Free Financial Planning Worksheets

Join our mailing list to receive your 2021 and 2022 Tax & Financial Planning Guide, as well as your Net Worth Statement and Spending Plan.