Revenue from sales of products or services is just one source of income for a business. A second income stream for many businesses is non-operating revenue from capital asset investments. Any business can hold capital investments, and many nonprofits rely on them for revenue. Businesses can realize profits or losses in either revenue steam — but when it comes to capital assets, cost basis is the key to how a business calculates its gains and losses.
There’s a wide spectrum of capital asset types in which businesses can invest, beginning with the stocks, bonds and money market funds where many park cash-on-hand until needed. But factories and equipment are also capital assets, as are goodwill, patents and copyrights. Cost basis is the key to determining the gain or loss for all these capital assets.
What Is Cost Basis?
Just as a business calculates the costs in creating products, it must keep careful records on the purchase of each capital asset, which is called the asset’s cost basis. The cost basis can change over time as depreciation is taken or capital improvements are made.
Cost basis vs tax basis — what’s the difference?
When the business disposes of a capital asset, it calculates and reports to the IRS the current adjusted cost basis of the asset, which is also called the tax basis. The profit or loss from the business’s investment in that asset is the difference between the sale price and the tax basis.
- Cost basis is the original price of a capital asset plus any costs associated with buying the asset.
- Capital gains or losses are computed by subtracting the cost basis from the market value at the time of sale.
- A business can choose from multiple cost basis methods to calculate the capital gain or loss.
Cost Basis Explained
When a business acquires a capital asset, such as stocks or other securities, real estate or even another business, the initial purchase price becomes the original cost basis of that investment. This initial cost basis includes any costs of acquiring the investment, such as attorney and advisor fees in the case of an acquisition. Cost basis for an asset can change over time for many reasons. Consider an office building: Taking depreciation lowers the building’s cost basis, but the cost of a new roof (which eventually will be required) is a capital improvement that adds to the cost basis.
Why Is Cost Basis Important?
The cost basis of an asset is important because it’s used to determine tax liability. When a capital asset is sold, the sale price minus the cost basis determines whether the investment is profitable. When an entire business is sold, the profit or loss of each capital asset must be determined separately using each asset’s cost basis.
Determining Cost Basis
The cost basis of an asset depends on the asset type and, in some cases, how the asset was acquired. Here’s a breakdown of the most common assets and how the cost basis for each is determined.
A business: The buyer divides the purchase price among all the capital assets in the business, assigning a cost basis to each asset. The value of an individual partner’s interest in a partnership is also considered a capital asset.
Stocks and bonds: The purchase price is the initial cost basis, including any brokerage fees or commissions, plus reinvested dividends (if any).
Gifted assets: The cost basis of assets given to a business is either the fair market value or the donor’s cost basis.
Inherited assets: The cost basis for inherited assets is the fair market value on the day the previous owner died.
Intangible assets: The cost basis for intellectual property, such as patents, copyrights, trademarks, trade names and franchises, is the cost to create or acquire those assets. In an acquisition, the cost basis for goodwill is the difference between the value of the company acquired and the amount paid for the business.
Calculating Cost Basis
How a business calculates cost basis for capital assets can become fairly complex — since different factors can apply to different capital investments — but they all start with the initial purchase price plus any costs of acquiring the investment. The purchase price includes not only cash, but also any amounts paid in debt obligations, services or real estate. Costs to acquire the investment can include sales, real estate and excise taxes; shipping costs; installation and testing charges; and commissions and fees.
Cost basis calculations get more complicated over time, as a cost basis is adjusted by subtracting or adding different factors. With stocks and bonds, for example, reinvested dividends are added to the cost basis. For real estate, depreciation is subtracted from the cost basis and any capital improvements are added. Maintenance costs, however, are an operating expense and do not affect the cost basis. So, a factory’s cost basis might include the initial cost of construction, minus depreciation over time, plus the major refit five years down the road — but not the salaries of the people who worked there all those years.
Tax Reporting Cost Basis
Well-kept records are key to proving an asset’s cost basis to the IRS. When a capital asset is sold, the gain or loss is calculated as the current market price minus the cost basis.
Why is cost basis reporting accuracy so important?
Cost basis reporting accuracy is vital because an asset’s adjusted cost basis becomes its tax basis for computing tax liability when the asset is sold. If the difference is positive, the business realizes a gain; if negative, it means a loss. The length of time the business holds the capital asset is also important in computing tax liability. Any investment asset held for more than one year is subject to capital gains tax, which could be 0%, 15% or 20% depending on the investor’s filing status and income for personal filings. Other tax rates will apply for businesses. For example, the tax rate for a C-Corp is currently 21%, regardless of income. And for certain types of assets, the capital gains rates can be up to 28%. Short-term investments — assets held for up to a year — are taxed as capital gains. The tax rate will be the same as the individual or corporate tax rate, but must be reported separately from income using a separate IRS form (8949) and 1049-D.
Cost Basis Methods
When a company buys multiple investments of the same type over time, such as shares of stock in the same company, determining the cost basis when the investments are sold can become fairly convoluted. The order in which the shares are sold can greatly impact the business’ ultimate gain or loss. When selling securities such as stocks, the IRS allows you to report using the special identification or first in, first out methods.
First In, First Out (FIFO): Using this method, stocks are sold in the order they were bought. If FIFO were applied to the example in the previous bullet, a business that sells 150 shares would have a cost basis of $10 each for 100 shares and $25 for the rest, for a cost basis of $2,250. At a sale price of $35 per share, it would realize a gain of $3,000.
Specific identification (SpecID): Using this method, the company identifies the stocks to be sold by specifying the acquisition date and price. That way, it could sell a custom mix with a cost basis of $10, $25 or $30 to achieve a specific cost basis to suit its needs.
Average cost (AvgCost): This uses the average cost of all shares purchased as the cost basis. Using average cost, if a business bought 100 shares of Company A’s stock at $10 per share, another 100 at $25 and 200 more at $30, the average cost per share (and, therefore, your cost basis for each share sold) would be $23.75 ($10 + $25 + $30 + $30 / 4). If the business sold 150 shares at $35 per share, it would realize a gain of $1,687.50 ($5,250 - $3,562.50).
Highest in, first out (HIFO): In this method, the highest priced stocks are sold first. So selling 150 shares from the example above would result in a cost basis of $30 per share and a realized gain of $750.
Last in, first out (LIFO): With this method, the stocks purchased most recently are sold first.
The IRS does not formally recognize AvgCost, HIFO or LIFO. However, the SpecID method allows for some flexibility. For example, when SpecID is used to indicate the most recent shares acquired, it’s essentially the LIFO methodology.
To decide which method works best for your business, you should consult a certified tax advisor or financial planner. Once you decide upon a method, the key is to keep it in effect.
Choosing a Cost Basis Method
Certainly, the fair market value of an asset plays a large part in deciding which cost basis method to use. FIFO is simple and has the virtue of maximizing gains if the asset value has increased while minimizing losses if the value has decreased. SpecID gives the company the most control in tax planning because specific shares can be selected for sale.
Cost Basis Comparisons
The table below shows the impact of applying cost basis methods to two scenarios. In both scenarios, Company A owns 300 shares of ABC company stock. The first 100 shares were bought at $400 each, the second 100 shares at $200 each and the third 100 at $600. Now the company wants to sell 150 shares and must decide which of the basis methods to use to maximize gains and minimize losses. The table shows how the methods compare in gains or losses for a scenario in which the share price has climbed to $700 and a second scenario in which the price has fallen to $300. As the table makes clear, the different cost basis methods yield different results in each scenario.
*Reminder: The IRS does not formally recognize AvgCost, HIFO or LIFO. However, the SpecID method allows for some flexibility.
Examples of Cost Basis
Most stock transactions are straightforward. The cost basis is the price paid plus any commissions, with little or no adjustment. In some special cases, however, such as mergers, stock splits and bankruptcies, the cost basis is affected by actions beyond the business’s control.
Mergers: If a business owns stock in a company that merges with another company, the business usually receives payment in stock, cash or a combination of stock and cash (called cash to boot). With stock payments, the merging company determines the new number of shares and market value, requiring an adjustment to the original cost basis. An all-cash merger is effectively the same as selling all shares, and the gain or loss is calculated at that time using the original cost basis. In cash-to-boot settlements, any fraction of a share resulting from the exchange ratio triggers a cash payment for that fraction.
Stock splits: When stocks split, the total investment does not change. The current cost basis is divided among the new number of shares. For example, in a 2-for-1 split, the cost basis of each share is cut in half.
Bankruptcies: If a business claims Chapter 7 bankruptcy, its shares lose all value. A loss cannot be claimed until either the company’s stock is sold (often for a penny) or is declared to be worthless. In Chapter 11, however, the shares could continue to be traded and, depending on the settlement, the cost basis could remain unchanged.
Tracking and Reporting on Cost Basis With Software
Given the need for a high level of reporting accuracy to produce trusted cost basis calculations for tax purposes, good business accounting software plays an important role. Software can help businesses keep detailed records of costs and dates of purchase for their capital assets. A range of business accounting software is available for tracking not only operating revenue and expenses, but also the cost basis for capital assets and other investments.
In addition to producing goods and services, businesses can realize a second stream of revenue from capital assets and capital investments. Many factors go into calculating the cost basis of an asset, including how it was acquired and the costs associated with acquiring it. Keeping careful records of the cost basis and acquisition dates of capital assets is essential for calculating gains and losses when the assets are sold. Good business accounting software can help with all that record-keeping, tracking and, when the time comes to sell an asset, identifying the best cost basis method to use for tax planning purposes.
Cost Basis FAQs
What does cost basis mean?
Cost basis is the total cost that an individual or business pays for a capital asset, whether a home, an office building or investment securities like stocks and bonds. It’s used to calculate the taxable gain or loss when the asset is sold.
How do you calculate cost basis?
Calculating cost basis can be simple or complex, depending on the circumstances. If you buy shares of a non-dividend-bearing stock from a no-fee online brokerage, your cost basis is the price you paid. But if you paid a commission, or if you invest in dividend stocks, then those fees get added into the cost basis when you sell. With property, like a home or office building, depreciation can lower the cost basis over time while capital improvements — for example, a new roof or HVAC system — add to the cost basis.
Do you pay taxes on cost basis?
You don’t pay taxes on the cost basis of an asset, but cost basis is used to calculate the taxable gain when an asset is sold. You pay tax on the difference between the sale price of the asset and the cost basis, i.e., Taxable gain = Sale price - cost basis. If you sell stock for $10,000 that originally cost you $9,000, you must pay tax on the $1,000 difference.
What is included in cost basis?
The initial purchase price is the core of the cost basis for any capital asset or investment. That includes costs of acquisition, like attorney and advisor fees. Over time, factors like depreciation of the asset or capital improvement can add or subtract from the cost basis of certain assets, like buildings. In the case of securities, reinvested dividends cause the cost basis for those securities to rise.
Is cost basis the same as cash basis?
Cash basis is an accounting method that records expenses or income when a payment is made or cash is received. It’s not as insightful as accrual accounting, which combines the current and expected future cash inflows and outflows. And cost basis is the cost of an asset and is used to determine taxable gain/loss when it’s sold.