Understanding Cost Basis

  • Your investment firm will track the cost basis for stocks acquired on or after January 1, 2011.
  • You can choose your tax lot relief method.
  • You are responsible for determining and reporting your cost basis on securities purchased prior to 2011.

Why is it important to understand cost basis?

When you sell an investment, you’re likely to incur either a capital gain or loss. If the investment was held in a taxable account, you can expect a capital gain to increase your tax bill and a loss to decrease it. As a result, it’s important to understand cost basis, which is a key factor in determining gains and losses.

How is cost basis calculated?

Cost basis is generally the original value of a security — usually the purchase price plus any fees and commissions — adjusted for stock splits, nondividend distributions (return of capital), and other corporate actions.

Your capital gain or loss is equal to the difference between the asset’s cost basis and the sales price of the closing transaction.

What’s the difference between covered and noncovered securities?

It’s important to understand your cost basis, which is a key factor in determining gains and losses.

Over the last several years, the IRS has phased in regulations that require financial institutions to track and report cost basis information. Securities falling under these regulations are referred to as “covered securities.” The effective dates of covered securities are:

Equity securities Acquired on or after January 1, 2011
Mutual fund and dividend reinvestment plan (DRIP) shares Acquired on or after January 1, 2012
Simple debt securities, such as fixed-rate bonds, original issue discount (OID) bonds and zero coupon bonds, options, rights, and warrants Acquired on or after January 1, 2014
More complex debt instruments Acquired on or after January 1, 2016

Sales transactions involving noncovered securities, assets purchased and held prior to these effective dates, continue to be reported as they have been in the past. This means financial institutions report only gross proceeds. It remains the investor’s responsibility to report noncovered security transactions, along with the proper cost basis, on their tax returns.

What’s a tax lot relief method?

A tax lot relief method is used to determine which lots of a security are liquidated first in a given sales transaction. In turn, it helps identify the cost basis and holding period of the asset sold.

Your capital gain or loss is equal to the difference between the asset’s cost basis and the sales price of the closing transaction.

A number of tax lot relief methods are available for you to choose from. In addition, the IRS requires all firms to establish a default tax lot relief method in the event a client does not designate his or her own specific method. Wells Fargo Advisors uses the First In, First Out (FIFO) tax lot relief method as its default.

Here’s how FIFO works:

Say you purchased 50 shares of ABC Company in January and another 25 shares in June. In July of the following year, you decided to sell 20 shares. Using the FIFO method, the first 20 shares you purchased (of the original 50) would be sold, and your cost basis (and profit or loss and holding period) would be determined based on those shares.

Along with choosing your own tax lot relief method, you can designate a specific tax lot for a given transaction. In the example above, you could have specified that 20 of the shares you purchased in June be sold, even if your chosen method would have specified different shares be liquidated first.

You should consult your tax advisor to determine the best tax lot relief method for your needs.

How long do I have to specify a tax lot?

Once a specific tax lot has been sold, federal tax regulations prohibit any changes after settlement date so cost basis information your investment firm reports for a covered security can be matched to the cost basis information you report on your federal income tax return.

Has anything else changed?

The revised regulations have also brought changes to:

  • Account transfers
  • Corporate action reporting
  • Wash sale reporting
  • Short sale reporting
  • S Corporation reporting
  • Tax forms

For information about these changes, contact a Financial Advisor with Wells Fargo Advisors.

Next steps

  • Talk to your Financial Advisor and tax advisor about your choices regarding tax lot relief methods.
  • If you need more information, contact a Financial Advisor with Wells Fargo Advisors.

Wells Fargo Advisors is not a legal or tax advisor.

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