For securities held outside of your retirement accounts (such as 401(k)s and IRAs) basis is most commonly what you pay (including transaction costs) for stocks, ETFs, mutual funds and other securities. However, certain events can impact basis—for example, with stock, it may “split” when companies merge or “spin off” a division, or shares might be gifted to another person. For shares acquired from an equity award from your employer, the basis is determined by a number of factors (see below).
The average investor/taxpayer has historically found it challenging to determine how much gain or loss relative to basis truly existed—simply because basis record keeping by many was either inaccurate or absent altogether. Things have gotten easier since brokers are now required to track and ultimately report basis for “covered” securities to both you and the IRS. (In general, this pertains to securities purchased after 2010.) But if shares were previously taxed as compensation, that portion of your basis cannot be reported to the IRS by your broker based on Treasury regulations from 2014.
Some examples of calculating basis
Let’s say you receive restricted stock units (RSUs) from your employer. When these RSUs eventually “vest” (i.e., become no longer restricted) and are delivered to you as shares of stock, the fair market value is $30/share. If you had 100 shares, $3,000 of income would be included on your W-2. Since you are taxed on that value, it becomes your basis in the shares received.
The problem is that the broker holding the shares not only won’t—but is prohibited from—reporting this basis to the IRS when the shares are sold. So if you sold the shares for $4,000, your taxable gain should be $1,000—however, $0 basis would be reported by the broker to the IRS, which would make it appear like your gain should be $4,000. The most important thing to remember is that it’s up to you to accurately track and report the compensation part of your basis to the IRS when filing your tax return. Otherwise, you could be taxed twice on that income!
Exercising stock options
Let’s say you receive 1,000 shares of non-qualified stock options with an “exercise price” (i.e., strike price) of $10 per share. You exercise these at full market value (FMV) of $30 per share. The income-taxable “spread” will be a total of $20,000 or $20 per share. The total spread needs to be reported on your W-2 for the year that you exercise those shares.
The broker will only record and report the basis as being $10 per share—the amount paid for the stock. The broker is not allowed to pickup the income component. The correct basis is $30 per share—the amount paid for the stock ($10 per share) plus the amount that will be recognized into income ($20 per share).
You will need to adjust the broker-reported basis of $10 per share upon sale by adding the $20 per share (you will need to know how to do this and will need to keep your own records to document).
You should also be aware of the situations where the basis reporting requirements arise including stock acquired through:
Understanding and keeping track of basis can be complex, but can yield significant tax savings. An Ayco adviser can give you the help you need to manage your tax situation and make sure you’re not paying more than you have to.
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Updated for tax year 2020
Updated for tax year 2019