Cost Basis Is the Starting Point for Every Gain or Loss

Cost basis is the amount an investor is treated as having invested in an asset for tax purposes, usually the purchase price plus any commissions and fees. When the asset is sold, the gain or loss is the sale proceeds minus the cost basis, so the basis decides how much of the sale is taxable.

Basis is not fixed. It rises with reinvested dividends and certain improvements, falls with returns of capital and depreciation, is spread across more shares after a split, and follows special rules when an asset is received as a gift or an inheritance.

Getting basis wrong is one of the most common ways investors overpay tax, and the exam tests it through calculations. For the full route from the exam to a career giving that advice, our complete guide to how to become an investment adviser representative covers every step.

Power up your January revision with the FRC Series 65 playlists on YouTube

Basis for a Simple Purchase

For investments bought for cash, the basis is the price paid plus transaction costs such as commissions. On a sale, commissions reduce the proceeds, so costs on both sides of the trade lower the taxable gain.

Worked example: an investor buys 200 shares at $50 and pays a $20 commission, so the basis is $10,020, or $50.10 per share. Two years later, she sells all 200 shares at $65 and pays another $20 commission, giving net proceeds of $12,980 and a long-term capital gain of $2,960.

Most trades in US stocks now carry no commission, but fees still apply to many other investments. The Series 65 Exam Preparation course at FRC works through basis calculations of every kind, including the fee adjustments examiners like to include.

How Basis Is Set by the Way an Asset Is Acquired

Reinvested Dividends and Capital Gain Distributions

When dividends or capital gain distributions are reinvested, the investor pays tax on them in the year they are paid, even though no cash is received. Each reinvestment buys new shares, and the amount reinvested becomes the cost basis of those shares.

Forgetting to include reinvestments in basis means paying tax on the same money twice. This mistake is especially common with mutual funds held for many years in dividend reinvestment plans.

Worked example: an investor puts $10,000 into a fund and reinvests $3,000 of distributions over the years, paying tax on each one. When she sells the shares for $18,000, her basis is $13,000, so the gain is $5,000, not $8,000; using only the original $10,000 would tax $3,000 a second time, costing an extra $450 at a 15 percent rate.

Stock Splits, Stock Dividends and Returns of Capital

A stock split does not change total basis; it spreads the same basis over more shares. If an investor owns 100 shares with a total basis of $8,000, or $80 per share, a 2-for-1 split leaves 200 shares with the same $8,000 basis, now $40 per share.

A stock dividend paid in additional shares is treated the same way. The original basis is divided among the old and new shares, and the new shares take the holding period of the original shares.

A return of capital is different. It is a repayment of part of the investor’s own money rather than a share of earnings, so it is not taxed when received, but it reduces the investor’s basis; once basis reaches zero, further returns of capital are taxed as capital gains.

Gifts: The Carryover and Dual Basis Rules

The recipient of a gift generally takes the donor’s basis, known as carryover basis, and includes the donor’s holding period. This means the unrealised gain passes to the recipient, who pays the tax when they sell.

A special rule applies if the asset’s market value at the time of the gift is lower than the donor’s basis. In that case, the recipient uses the donor’s basis to measure a gain but the lower market value to measure a loss, which stops donors passing on tax losses through gifts.

Worked example: a donor’s basis is $20,000 and the shares are worth $15,000 when gifted. If the recipient sells for $25,000, the gain is $5,000, measured from the donor’s basis. If she sells for $12,000, the loss is $3,000, measured from the $15,000 market value. If she sells for anywhere between $15,000 and $20,000, such as $18,000, there is no gain and no loss.

Inheritances: The Step-Up in Basis

Assets inherited at death generally receive a new basis equal to their market value on the date of death. When that value is higher than the original cost, the basis is stepped up and all the unrealised gain during the owner’s lifetime escapes income tax.

Worked example: a father bought shares for $40,000 decades ago, and they are worth $250,000 when he dies. His daughter inherits them with a basis of $250,000, and if she later sells for $260,000, her taxable gain is only $10,000, always treated as long-term.

The step-up works in reverse for assets that have fallen in value, giving a stepped-down basis and wiping out the unrealised loss. In community property states, both halves of community property can receive a new basis when the first spouse dies, which can make a large difference for surviving spouses.

Study Investment Taxation With FRC

Basis questions combine arithmetic with rules that depend on how the asset was acquired, and examiners often hide the key fact in the wording. Our Series 65 course teaches a clear method for every case, from simple purchases to gifts at a loss.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Choosing Which Lots to Sell

When an investor has bought the same security at different times and prices, each purchase is a separate tax lot with its own basis and holding period. The method used to decide which lots are sold can change the size and character of the gain.

First in, first out is the default for stocks, selling the oldest shares first. Specific identification lets the investor choose particular lots, such as the highest-cost shares to minimise the gain, and the average cost method, available for mutual funds and some dividend reinvestment plans, uses the average basis of all shares held.

Worked example: an investor bought 100 shares at $20 and later 100 shares at $50, and now sells 100 shares at $60. Under first in, first out, the gain is $4,000; by specifically identifying the $50 lot, the gain is $1,000; under average cost, with an average basis of $35, it is $2,500.

How Brokers Report Basis

Brokers must report the cost basis of covered securities to the IRS and to the investor on Form 1099-B when they are sold. Stocks bought from 2011, mutual fund shares and dividend reinvestment shares bought from 2012, and most bonds and options acquired from 2014 onwards are covered securities.

For securities bought before those dates, called noncovered securities, the broker may not know or report the basis. The investor is responsible for proving it from purchase records, which is why keeping confirmations and statements matters.

When accounts move between brokers, basis information for covered securities must transfer with the assets. Advisers who take on a new client should check that basis records arrived intact, especially for inherited or gifted positions.

Basis for Bonds

A bond bought at a premium, above its face value, has its basis reduced over time as the premium is amortised; for taxable bonds the investor can choose to amortise, while for tax-exempt bonds amortisation is required. A bond bought at a discount at issue has original issue discount, which is added to basis each year as it accrues and is taxed as interest.

The adjustments mean a bond held to maturity usually produces no capital gain or loss, because its basis has moved to its face value by the time it matures. Selling before maturity measures the gain or loss against the adjusted basis, not the original price.

Accrued interest paid when buying a bond between coupon dates is not part of basis; it is recovered from the next coupon. Our article on how to calculate accrued interest for a bond that pays interest at maturity explains the calculation.

Basis and the Wash Sale Rule

If an investor sells a security at a loss and buys a substantially identical security within 30 days before or after the sale, the loss is disallowed under the wash sale rule. The disallowed loss is not lost forever: it is added to the basis of the replacement shares.

The adjustment means the tax benefit is postponed until the replacement shares are sold. The holding period of the original shares also carries over to the replacement shares.

Advisers harvesting tax losses therefore wait more than 30 days before buying back the same security, or buy a similar but not substantially identical investment, keeping the client’s asset allocation intact in the meantime.

The Memory Aid

Remember “basis is what you put in, adjusted for what changed”. Add commissions, reinvestments and improvements, and subtract returns of capital, depreciation and amortised premium.

For gifts, remember “gain uses the giver, loss uses the lower”: the donor’s basis for a gain, the lower market value for a loss when value had fallen below basis at the time of the gift.

For inheritances, remember “death resets the clock and the cost”: the basis becomes market value at death and the holding period is always long-term.

Exam Traps to Avoid

The first trap is forgetting to add reinvested dividends to basis. They were already taxed, so leaving them out taxes them twice.

The second trap is assuming a stock split creates a gain or changes total basis. It only spreads the same basis across more shares.

The third trap is applying the donor’s basis to a loss on gifted property whose value had fallen below basis at the time of the gift. The lower market value applies for measuring a loss. The fourth trap is using the original purchase price for inherited property; the stepped-up value at death applies.

A Client Scenario

A client in the 15 percent long-term capital gains bracket wants to sell a mutual fund she has owned since 2009 in a dividend reinvestment plan. Her broker’s statement shows the basis as unknown, and she assumes her basis is the $25,000 she originally invested.

The adviser explains that the fund shares bought before 2012 are noncovered, so the broker may not have the full basis, but that she has reinvested and paid tax on about $14,000 of distributions since then. Reconstructing the basis from old annual statements raises it to about $39,000.

On a sale value of $70,000, the correct gain is about $31,000 rather than $45,000, saving around $2,100 in tax at 15 percent. The adviser documents the basis calculation, reviews the sale against her goals and risk tolerance, and confirms the suitability of the reinvestment plan for the proceeds.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Use the FRC dictionary to open every term in this article as its own explanation, video and quiz.

Practice Questions to Test Yourself

Question one: An investor buys 100 shares at $40 with a $10 commission. What is the cost basis per share? $40.10, because the $4,010 total cost is divided by 100 shares.

Question two: An investor owns 300 shares with a total basis of $9,000, and the company declares a 3-for-1 split. What is the new basis per share? $10, because the $9,000 basis is now spread across 900 shares.

Question three: A donor’s basis is $30,000 and the shares are worth $22,000 when gifted. The recipient sells for $26,000. What is the gain or loss? Neither, because the sale price falls between the $22,000 market value used for losses and the $30,000 donor basis used for gains.

Question four: An heir inherits shares that cost $5,000 and were worth $60,000 at death, and sells them two months later for $62,000. What is the gain and its character? A $2,000 long-term gain, measured from the stepped-up basis of $60,000.

Question five: A fund pays a $500 return of capital to an investor whose basis is $4,000. What happens to her basis? It falls to $3,500, and the $500 is not taxed when received.

Turn Tax Knowledge Into Career Evidence

Accurate basis records can save clients real money, and firms value advisers who catch the errors other people miss. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining clearly how a stepped-up basis or a missing reinvestment changes a client’s tax bill shows practical skill that sets you apart.

Candidates returning to the exam should note that the wait after a third failure drops from 180 days to 60 days for exam windows opened on or after January 4, 2027, as explained in our article on the Series 65 retake rule change.

Related Questions

Continue with Short-Term vs Long-Term Capital Gains for the rates applied once the gain is known, and Traditional IRA vs Roth IRA for accounts where basis rarely matters.

For moving accounts without creating a taxable event, read IRA Rollover vs IRA Transfer, and for a tax-free exchange of insurance contracts that carries basis over, see What Is a 1035 Exchange?.

Key Points to Retain

Cost basis is the amount invested for tax purposes, generally the purchase price plus costs, and the gain or loss on a sale is the net proceeds minus the adjusted basis. Basis rises with reinvested dividends and capital gain distributions, falls with returns of capital, and is spread across more shares after a split or stock dividend.

Gifted property usually carries over the donor’s basis, with the lower market value used for losses when value had fallen below basis, while inherited property takes its value at death and is always long-term. Lot selection methods change the gain on a partial sale, brokers report basis for covered securities, and a wash sale adds the disallowed loss to the basis of the replacement shares.

For the exam’s structure and requirements, see the Series 65 dictionary entry, and for the role the exam leads to, read our guide to what an investment advisor representative is.