What is tax basis

What Is Cost Basis And Why Is It Important?

The more someone makes, the higher their taxes will be. And these taxes are based on a person’s “tax basis” (or “cost basis”), which is the total amount of money that they have earned combined with anything that they received from other sources.

Knowing what your tax basis is can help you to calculate the accurate amount of taxes per transaction you’ll have to pay. 

It can be challenging to figure out how these numbers work together in order to find your tax basis. So we created this article with some examples and explanations to make it easier for you. 

Contents:

Basis definition: What does cost basis mean?

Why Is Tax Basis Important?

How To Calculate Your Tax Basis

Basis definition: What does cost basis mean?

The term basis is used to refer to the amount of investment a taxpayer has in business assets. The taxed capital gain depends on the rate of your tax basis. When the tax basis is going up, the taxed capital gain is going down. 

If you’ve ever filed your taxes, you’ve probably wondered what the numbers like “taxable income,” “adjusted gross income,” and “taxable interest” are. These are all components of the tax basis. 

The tax basis is the dollar value of assets that are subject to taxation when they are sold or exchanged during a given year after deducting any depreciation, amortization or depletion. This includes things like stocks, bonds, mutual funds, real estate property, and more. It will be used to calculate potential capital gains on any future transactions involving the asset.

As the tax basis represents the value of the assets at the time you acquire them, the difference between the initial value and current-day value is what potentially could be taxable. 

🔎 Example: If you acquired $10,000 worth of stock and sold it for $15,000, your taxable gain would be $5,000. If you then sold that same stock for $18,000, your taxable gain would be $8,000. This is because only profits made over your current tax basis are taxable. 

Why Is Tax Basis Important?

You will be taxed on your income from your employment, your investments, and income from other sources such as interest and dividends.

The more money and investments you have, the higher your taxes are. So make sure to use your tax basis to determine what you owe the IRS.

Types of cost basis methods:

The Internal Revenue Service (IRS) has a set of rules for determining taxable income, and it can be a confusing process to calculate. 

The cost basis method determines whether you should pay taxes on the dollar value of a sale or whether you should be taxed on the price that you receive.

  1. First in, first out (FIFO). A more complex method of calculating the tax basis. In this method, you first calculate the purchase amount of the asset by determining its price on the day of the transaction. The money for taxes is then added to the purchase price and the amount is used to calculate the tax basis.
  1. Last in, first out (LIFO). The LIFO rule basically states that if a company sells something at full cost (the most expensive part), they will first sell it at full price and take the difference out of their profit and apply that to the cost of the next shipment.
  1. Specific identification. This method allows the investor to choose which assets are sold in order to optimize the tax treatment. 

How To Calculate Your Tax Basis

Determining your tax basis is an important step in calculating the capital gains tax on any investment. Your capital gains tax is based on how long you have owned the asset, the type of asset, and your tax bracket. 

Many people think that a tax is a one-time thing, but in fact, it’s an ongoing process. The amount of income you owe in taxes every year depends on your tax rate and the amount of money you make.

For most Americans, it’s important to know that you can calculate your tax basis any time of the year for your state of residence. If you’re unsure how to calculate this yourself, you can use the general formula to calculate a tax basis:

Tax basis = original cost of the assets + purchase costs +/- adjustment

Purchase costs: sales commissions, shipping fees, etc.

Adjustments (unrecovered cost): stock splits, dividends, etc.

📌 The tax basis is decreased by annual depreciation and increased by capital improvements and reinvested dividends.

The tax basis also depends on how you got the assets. This is how you can calculate your tax basis in each case:

  1. Purchases: in this case you need to pay attention to what you pay + the commissions;
  1. Inheritance: if you inherited assets from another person the value of the assets equals the price on the date of the previous owner’s death;
  1. Stock and bonds: choosing this option, pay attention to the stock price + the fees and commissions;
  1. Gift: if you sell for profit: tax basis = the previous owner’s cost basis; if for loss: tax basis becomes the lower of either the market value on the date when you receive the gift or the previous owner’s cost basis; 
  1. A business: when buying a business a person assigns each business asset on a tax basis as a portion of a particular purchase price;
  1. Partnership: in partnership you need to keep in mind that each partner’s tax basis is the net value of the partner’s contribution and share of liabilities + any income earned. 

Wrapping up, the tax basis can be also described as the adjusted basis of an asset. But at the particular time when the asset is sold. It may be hard to keep all the transactions’ records accurate. Especially at the time when you need to spend an extra all-nighter checking all the documents. But it has to be done to keep an eye on every business asset’s original cost basis and each adjustment that may affect the asset’s cost basis over time. 

The best tip on how to do these calculations correctly without harm to your everyday life is to manage your time wisely from the first day. Don’t dally off dealing with the tax basis. If you don’t get down to it in time, you may end up piling the work and problems.

Anastasia Su

Anastasia Su

Anastasia is a FinTech writer with experience in working as a freelance writer for small business owners for the last two years. She participated in numerous events dedicated to business management and marketing. Anastasia is inspired by the fact that each successful business is a result of proper structuring so she tries to analyze every step.

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