Cost Basis

Cost basis is the original value of an asset for tax purposes, usually the purchase price, adjusted for stock splits, dividends and return of capital distributions. This value is used to determine the capital gain, which is equal to the difference between the asset's cost basis and the current market value. The term can also be used to describe the difference between the cash price and the futures price of a given commodity.

Using the correct cost basis, also referred to as the tax basis, is important especially if you reinvested dividends and capital gains distributions instead of taking the earnings in cash. Reinvesting distributions increases the tax basis of your investment, which you must account for to report a lower capital gain and therefore pay less tax. If you don't use the higher tax basis, you could end up paying taxes twice on the reinvested distributions.

For example, if 100 shares of a stock were purchased for $1,000 last year, with the first year of dividends amounting to $100 and second year dividends amounting to $200, all of which was reinvested, applicable tax law considers these reinvested earnings to be income. For tax calculation purposes, the adjusted cost basis when the stock is sold will be recorded at $1,300 instead of the original purchase price of $1,000. Thus, if the sale price is $1,500, the taxable gain would only be $200 ($1,500 - $1,300) instead of $500 ($1,500 - $1,000). If the cost basis is incorrectly recorded as $1,000, this results in a higher tax liability than would normally be due.

In regards to futures, the cost basis is the difference between a commodity’s local spot price and its associated futures price. For example, if particular corn futures contract happens to be trading at $3.50, while the current market price of the commodity today is $3.10, there is a 40-cent cost basis. If the reverse were true, with the future contract trading at $3.10 and the spot price being $3.50, the cost basis would be negative 40 cents, as a cost basis can be positive or negative depending on the prices involved.

The local spot price represents the prevailing price for the underlying asset, while the price listed in a futures contract refers to a rate that would be given at a specified point in the future. Futures prices vary from contract to contract depending on the month when they are set to expire.

As with other investment mechanism, the spot price fluctuates depending on current local market conditions. As the delivery date approaches, the price of futures and the spot price shift closer together.