Cost basis

When you buy a stock or other security, the cost basis is the amount that you paid to buy the share. When you sell shares, you compare the price you sell them for with the price you paid to determine the gain or loss for reporting your capital gains taxes.

You can choose to sell shares a few different ways to help manage your tax strategy from year to year:

• First-in, first-out (FIFO): You select to sell the shares you bought first, which is the default method for your Robinhood account.
• Last-in, first-out (LIFO): You can ask Robinhood to set trades to sell the most recently purchased (last in) shares first for tax purposes.
• Specific identification: Choose individual shares to sell and use the cost basis of the specific shares, regardless of order.
• Average-cost: For most ETFs, you can use this method to sell ETF shares based on the total amount you paid to buy all of them divided by the number of shares you own. This is the easiest method, but requires you to continue using the average cost of all until you sell all your shares.

Keep in mind, the cost basis for an investment can change for a few different scenarios. For example, if you inherit a security from someone who has passed, its cost basis is usually the value of the security on the date of the person’s death. Also, if a company pays a dividend and then later reclassifies all or part of the dividend as a return of capital, it will reduce your cost basis.

To calculate the cost basis for individual shares that you own, you need to find the price that you paid for the share, then multiply it or divide it based on any stock splits or reverse splits that occurred.

Let’s say you buy 1 share of an ETF monthly over 1 year: 5 shares for $10, 3 shares for $15, 2 shares for $20, and 2 shares for $25. Each share has an individual cost basis, but the total cost basis for the 12 shares is:

(5 * $10) + (3 * $15) + (2 * $20) + (2 * $25) = $185

Let’s say, you decide to sell all 12 shares for the current ETF market price of $30, which equals a $360 sale. Minus the $185 cost basis, you’d earn $175 of capital gain income, minus any SEC or other fees.

To keep your capital gain low, you can use the LIFO method and sell the 2 ETF shares you bought for $25 for the market price of $30, for only a $10 gain.

Or to maximize your capital gains, you can use the FIFO method and sell the 5 shares you bought at $10 for a $100 gain.

With the average-cost method, the average cost basis for the group of ETF shares is $185 divided by 12 shares, which equals ~$15.42 per share. This method simplifies the calculation of your cost basis but makes it difficult to control the amount (and when) you pay in taxes by selling specific shares. It also requires you to use the average cost for all future sales until you sell every share you own in the group of shares you bought, such as for an ETF.

Stock splits don't affect your overall cost basis for an investment, but they do change your per-share cost basis. To find the new cost basis per-share after a stock split, you must divide your per-share cost basis based on the size of the stock split.

For a reverse split (which combines multiple shares into one), you’d multiply the per-share basis based on the size of the reverse split.

Corporate actions can also affect the cost basis for shares you own. If a company goes through a corporate action, they’ll publish information about how the cost basis should be calculated moving forward. You’ll need to take note of these when calculating your cost basis for any of that company’s shares that you own. We’ll update the cost basis information based on what is published by the company to ensure proper tax reporting.

Cost basis is important for tax purposes because you use it to determine your realized gains and losses. When you sell an investment for more than its cost basis, you realize a gain, which you may have to pay taxes on. If you sell for less than the cost basis, you’d realize a loss. In many cases, you can deduct that loss from your investment income on your tax return, reducing the capital gains tax you owe.

Knowing your investments’ cost basis and managing the tax basis of the investments that you sell can help you manage your investment efficiently, potentially reducing the taxes that you pay.

Keep in mind, IRAs are not subject to capital gains tax. But you may pay ordinary income tax and, if applicable, a penalty tax upon withdrawing funds from an IRA.

This is not a recommendation of a security or an investment strategy. Robinhood does not provide tax advice. Before deciding on a cost basis strategy, consider consulting a tax professional.