Strike Price

Cost Basis is the original value of an asset, such as a stock, bond, or real estate, for tax purposes. It includes the purchase price of the asset plus any additional costs incurred to acquire the asset, such as commissions, fees, and improvements. The cost basis is used to calculate capital gains or losses when the asset is sold.

Key Features:

Purchase Price: The initial amount paid to acquire the asset.

Transaction Costs: Additional fees such as broker commissions, transaction fees, or other acquisition-related expenses.

Adjustments: The cost basis may be adjusted over time for events like stock splits, dividends, or capital improvements (for real estate).

Capital Gains/Losses: The cost basis is essential for determining the capital gain or loss when the asset is sold. The formula is:

Capital Gain or Loss =  Selling Price − Cost Basis

Tax Implications: The cost basis is used to determine the taxable amount when the asset is sold. A higher cost basis results in lower taxable gains.

Options Trading Impact: When options, such as covered calls, are involved, they can reduce the cost basis of the underlying stock. This happens because the premium received from selling the option (such as the call option premium) can be subtracted from the cost basis of the stock. This reduction in cost basis can potentially reduce the capital gains tax liability when the stock is sold.

Importance of Cost Basis:

Tax Reporting: Cost basis is crucial for calculating how much capital gains tax an investor must pay when selling an asset.

Investment Strategy: Knowing your cost basis helps you understand the profitability of your investments and manage your portfolio effectively.

Capital Gains Calculation: The cost basis directly affects how much capital gain is realized upon the sale of an asset.

Options Trading: In options trading, especially covered calls, the premiums received can lower the cost basis of the underlying stock, which can reduce the amount of taxable capital gains upon sale.

Top 10 FAQs:

What is included in the cost basis?
The cost basis includes the original purchase price of the asset, plus any transaction fees or commissions, and any other costs incurred when acquiring the asset.

How does cost basis affect taxes?
Cost basis is used to calculate taxable capital gains or losses when an asset is sold. The higher the cost basis, the lower the taxable gain.

Can the cost basis change over time?
Yes, the cost basis can be adjusted due to stock splits, reinvested dividends, or capital improvements made to the asset.

How does options trading reduce the cost basis?
When you sell an option, like a covered call, you receive a premium. This premium is subtracted from the cost basis of the stock you own. For example, if you purchased a stock for $100 per share and sell a call option for a $5 premium, your adjusted cost basis would be $95 per share.

How do I calculate my capital gains using cost basis?
To calculate your capital gain or loss, subtract the cost basis from the selling price of the asset. If the selling price is higher than the cost basis, you have a capital gain; if lower, you have a capital loss.

What happens if I don’t know my cost basis?
If you don’t know your cost basis, you may have to estimate it using the information available or rely on your broker to provide the cost basis of your assets.

How is cost basis different from market value?
Cost basis is the original purchase price of an asset, while market value is the current price of that asset. Cost basis is used for tax calculations, while market value helps determine the asset’s worth in the market.

Do dividends affect cost basis?
Dividends generally do not affect cost basis unless they are reinvested to purchase additional shares. In that case, the reinvested dividends increase the cost basis.

What happens to cost basis in the event of a stock split?
In a stock split, the cost basis is adjusted to reflect the increased number of shares. For example, in a 2-for-1 stock split, the cost basis per share is halved, but the total cost basis remains the same.

Example:

You purchase 100 shares of a stock at $50 per share, with a $10 commission fee. Your total cost basis is:

Cost Basis= (100×50)+10=5010

If you then sell a covered call and receive a $5 premium per share, your adjusted cost basis becomes:

Adjusted Cost Basis= 5010− (100×5) = 5010−500 = 4510

If you later sell the shares for $60 each, the capital gain would be:

Capital Gain = (100×60) − 4510 = 6000 − 4510 = 1490