Basis, as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays/ taxes on a capital gain/ that equals the amount realized on the sale minus the sold property’s basis.
The cost basis is the price of an asset or security determined for taxation purposes. The cost basis includes the commissions, expenses, profits, losses, interest or any fees to determine the net gain on which taxes are applicable. The cost basis of an asset changes as time passes on. This is particularly true in stocks and bonds.
Another use of cost basis is to calculate the capital gains tax, which is the tax levied on any profit earned during a financial transaction. This is done by subtracting the cost basis of an asset from its market value at present.
Calculating the cost basis
The methods of calculating the cost basis are numerous, and vary widely in terms of simplicity, and complexity. For instance, in case the asset is the only purchase, and you need to determine the cost basis right after the purchase is completed, then the cost basis will be equal to the price of the asset.
While selling the asset, such as the stock or bond, you need to calculate the cost basis in order to determine the profit on which tax would be applicable. There are various methods to do that. Some of them are:
Simple cost basis calculations
The key to understanding how to calculate a cost basis is to simplify it. Although the financial transactions in real life are significantly more complicated, we need to consider a basic example to gain an understanding of the methods to calculate the cost basis. For instance, if you brought a product for $10 and sold it at $15, then there is a capital gain of $5, and this is the amount on which the tax will be deduced. And the $10 dollars purchase price is the cost-basis for the transaction.
First In, First Out (FIFO)
The FIFO method is used to determine the cost basis by including the price of the first assets you purchased in a series of purchases. This is the method most commonly utilized by the Internal Revenue Service (IRS). The IRS tracks the inventory to determine which of the purchase was made first, and includes that price into the cost basis formula when a sale is made.
Last In, First Out (LIFO)
As the name suggests, LIFO is the method in which the most recently sold products are used to calculate the cost basis and the capital gains for taxation purposes. This method allows the sellers to significantly reduce the income tax in times of inflation.
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