Legal Definitions - cost basis

Cost basis refers to the original value of an asset for tax purposes. It typically includes the purchase price along with any associated costs incurred to acquire and prepare the asset for use, such as commissions, fees, or significant improvements.

This figure is crucial for calculating the taxable profit (known as a capital gain) or deductible loss (known as a capital loss) when the asset is eventually sold or transferred. If an asset is received as a gift, its cost basis is generally the same as what the original owner paid for it.

Here are some examples to illustrate how cost basis works:

• Real Estate Purchase: Imagine Sarah buys a house for $300,000. She also pays $10,000 in closing costs (like legal fees and title insurance) and later spends $50,000 on a major kitchen renovation and adding a new deck. When Sarah eventually sells the house, her cost basis isn't just the $300,000 purchase price. Instead, it would be $300,000 (purchase price) + $10,000 (closing costs) + $50,000 (capital improvements) = $360,000. This higher cost basis will reduce the amount of capital gain she has to report for tax purposes when she sells the house.

• Stock Investment: John purchases 100 shares of Company X stock at $50 per share and pays a $10 brokerage commission for the transaction. His total outlay is (100 shares * $50/share) + $10 = $5,010. His cost basis for these 100 shares is $5,010. If he later sells these shares for $7,000, his capital gain would be $7,000 (selling price) - $5,010 (cost basis) = $1,990. The cost basis ensures that he only pays tax on the actual profit he made after accounting for all acquisition expenses.

• Gifted Artwork: Maria receives a valuable antique sculpture as a gift from her grandmother. Her grandmother originally purchased the sculpture for $5,000 many years ago. At the time Maria receives it, the sculpture is appraised at $20,000. If Maria decides to sell the sculpture a few years later for $25,000, her cost basis for tax purposes is generally her grandmother's original purchase price of $5,000, not the $20,000 value when she received it. This means her capital gain would be $25,000 (selling price) - $5,000 (cost basis) = $20,000, on which she would owe taxes.