Not Knowing Your Cost Basis Can Be Taxing

Most of us are familiar with the term cost basis in the context of investments, but perhaps haven’t given enough thought to other assets that carry a basis. When it comes time to sell, it is important to have a complete accounting of tax basis to ensure that your tax bill isn’t higher than it should be.

Your Securities

When you sell a stock or other security, your capital gain is the difference between the sales proceeds and your cost basis, which is what you paid for the security plus any additional investments, such as dividends. Determining the cost basis on a security such as a stock or mutual fund is often problematic, especially if the security had been purchased many years prior to the sale, if it holds reinvested dividends, or was a gift from a parent or grandparent. Historically, the recordkeeping burden fell to the investor to determine the cost basis, and still does for securities purchased prior to 2011 for stocks, 2012 for mutual funds, and 2014 for bonds. But for securities purchased after those years, financial institutions are required to report cost basis and transfer the basis along with the security if the investor moves the security to another institution. That has made tracking cost basis less problematic but didn’t solve the problem for securities that were purchased before the new rules were put into effect.

Your Home

Homeowners may be thrilled with the increasing values of their homes, but may be due for a big surprise if they sell their home and find that they must pay a large capital gains tax. Prior to 1997, homeowners could roll over the gain on their old house to their new house. But now taxable capital gains are based on the sales price less selling expenses, less the cost basis, and less either $250,000 (single owner) or $500,000 (couple) for a principal residence, as long as the owners have lived in the house for a certain period of time. Those figures have not increased since 1998, although legislation has been introduced, but not passed, to adjust the figures for inflation, with the result being that more and more people have faced capital gains taxes when they sell their house. (According to a document prepared by the Congressional Research Service, if the $250,000 and $500,000 figures had been increased to reflect the change in the average housing price between 1997 and 2025, they would now be approximately $720,000 and $1,440,000, respectively.)

Not only may the home seller have to pay capital gains tax, but if high enough, the capital gains may extend into the 20% capital gains bracket, rather than the 15% bracket that might normally apply, and trigger the 3.8% net investment income tax. And finally, the gain could push people over age 65 into a much higher Medicare premium bracket, although that would apply for just one year.

But regardless of the outcome of any efforts by Congress to increase the dollar exclusions, it is important to keep records not only of the purchase price of your home, plus any associated expenses, but also the additional capital improvements that have been made over the years. These improvements must be expenses that affect the basis in the property, excluding costs for maintenance or repairs. They include any work done that adds to the value of your home, increases its useful life, or adapts it to new uses. These might include, for example, room additions, new bathrooms, decks, fencing, landscaping, wiring upgrades, new walkways or driveways, kitchen upgrades, plumbing upgrades, and a new roof.

Many people may not realize that you can increase your tax basis by adding the value of tax credits you received for home energy improvements, the cost of extending utility lines to your property, and any costs you may have been assessed by your local government that improved the value of your property, such as street paving or curbing. Remember, the higher the cost basis, the lower the capital gain.

You need to document each element of your home's tax basis. The original cost can be documented with copies of your purchase contract and closing statement. Improvements should be documented with purchase orders, receipts, cancelled checks, bank statements showing any electronic payments, and any other documentation you receive.

Traditional IRAs

For most people with Traditional IRAs, cost basis is not an issue because the money is all pre-tax, meaning that contributions were either deductible from income on your tax return or they were originally made to a retirement account such as a 401(k) or 403(b) directly from your paycheck and not included in the W-2 you received to prepare your tax return. That means that when the money is withdrawn, the entire withdrawal is taxable at ordinary income tax rates.

However, you may have an IRA that also includes after-tax contributions, which are not taxable upon withdrawal. This could be the case if, in order to benefit from tax-deferral on the earnings, you (1) made Traditional IRA contributions that were not tax-deductible because your income exceeded certain limits and/or you were covered by an employer-sponsored retirement plan at the time, or (2) you contributed to an after-tax savings plan at work. If either of these applies to you, you need to determine your basis, which is the sum of all the after-tax contributions you made. When you make withdrawals from the Traditional IRA, the portion of the withdrawal represented by your basis is not taxed. That portion is tracked on a Form 8606 in any year you made a nondeductible Traditional IRA contribution or took a withdrawal from a Traditional IRA that had a basis.

Taxpayers in Massachusetts who made contributions to a Traditional IRA have a separate issue. IRA contributions are not deductible on your Massachusetts tax return, even if they are deductible on your federal return. That means you may have a state IRA basis, which is the sum of all your IRA contributions made while you were living in Massachusetts. When you make withdrawals, your basis is deemed to be withdrawn first and is not taxed at the state level. Once you have withdrawn your entire basis, any remaining withdrawals are fully-taxable.

Trump Accounts

Starting this year, parents can open a Trump Account for a child. Parents, guardians, grandparents and others will be allowed to contribute up to $5,000 a year in after-tax dollars until the year before the child turns 18. After that, the account becomes an IRA and is basically subject to the rules pertaining to Traditional IRAs, including contribution limits and withdrawal restrictions.

Employers can also contribute up to $2,500 per worker, per year, which is part of the $5,000 limit and won’t count as taxable income, according to the IRS. Additionally, qualifying charitable organizations and state and local governments may make contributions that do not count toward the $5,000 limit.

For children born in 2025-2028, the government will deposit $1,000 into each Trump account. For children under 10 but born before 2025, Michael and Susan Dell will contribute $250 to each account for families living in zip codes with a median income under $150,000.

Because Trump accounts will become Traditional IRAs when the child reaches age 18 and will have a mix of pre-tax and after-tax money, they will have a basis, similar to IRAs with non-deductible or after-tax contributions. When withdrawals are made or if the accounts are converted into Roth IRAs, contributions made with after-tax money and any contributions made by an employer will not be taxable. But the earnings that have accumulated are fully taxable, as is the $1,000 seed money from the government as well as any gifts to the account made by a charitable organization. It will be important to keep a record of all contributions to ensure that the money contributed after-tax will not be taxed again.

To eliminate the need to keep records for the child’s entire lifetime, the child could convert the Trump Account to a Roth IRA soon after reaching the age of 18. Income taxes will be due but it is likely that the child will be in a low tax bracket at that stage in life. However, the conversion should be delayed until at least January 1 of the following year and not while the child is in college and still a dependent, because the “kiddie tax” would apply and the conversion would be taxable at the parents’ tax rate. Once the account becomes a Roth IRA, it can grow tax-free and eventually withdrawn tax-free, subject to the rules governing Roth IRAs.

If you have questions on this topic, please reach us at (833) 888-0534 x2 or info@westbranchcapital.com.

The views and information contained in this article and on this website are those of West Branch Capital LLC and are provided for general information. The information herein should not serve as the sole determining factor for making legal, tax, or investment decisions. All information is obtained from sources believed to be reliable, but West Branch Capital LLC does not guarantee its reliability. West Branch Capital LLC is not an attorney, accountant or actuary and does not provide legal, tax, accounting or actuarial advice.