In the investing world, the term “cost basis” means the original purchase price of an asset. Although there are some circumstances where the cost basis can be adjusted, such as a so-called step up to date of death or adjustments due to like-kind exchanges like a 1031 exchange or stock exchange, most of the time cost basis is based on the value on date of purchase.

The “capital gain” on an asset is the current value of an asset minus its cost basis. If that value is negative, we call it a “capital loss.”

If you still own the asset, the capital gains are said to be “unrealized.” Unrealized capital gains are sort of like theoretical gains. They are an “if you sold the asset now, then you would have a capital gain.”

Once you sell the asset, then you have realized the gain.

The value of the asset at sale minus the cost basis is then used to calculate the final value of the realized capital gain or loss, although there are some circumstances where the sale price of the asset can be adjusted.

When it comes to a security, the cost basis is adjusted by any fees and commissions paid. As a result, the cost basis of a security is the purchase price of the holding (number of shares multiplied by the price per share at the time of purchase) plus any fees and commissions paid. A higher cost basis is a good thing for the owner; it will result in a lower capital gain at the time of sale.

When you purchase a large number of shares of a security, you may find that the shares are broken into more than one trade lot even when purchased on the same day. One set of trade lots may be 500 shares with a price of, say, $29.00 per share. Then, on the next set up trade lots may be 500 shares with a price of, say, $29.01 per share because your first set of trade lots increased the cost for your second set.

Furthermore, some people utilize “Dividend Reinvestment Plans,” commonly abbreviated DRIPS. A dividend is a portion of a company’s earnings paid to the shareholders. Dividend reinvesting is an automated service that brokers provide where instead of receiving the dividend as cash, dividend payments are used to purchase additional shares of the stock or fund that generated them. Dividends paid as cash are not included in the cost basis of a holding, but dividends reinvested have their own trade lot and cost basis to track.

Also, there are several corporate actions which can adjust cost basis. For example, a company can engage in a “split,” where they adjust the number of outstanding shares, or two companies may merge as one buys the other. When a company decides to do a stock split, they will announce the split as a ratio, such as three-for-one. The first number is the important factor. You increase the number of shares you own by this factor while decreasing the share price by the same factor.

In this way, cost basis calculations can become very complicated, especially when there are multiple trade lots, reinvested dividends, splits, and sells.

Here’s a complex example.

Imagine that you bought 100 shares of a company at $50 per share (fees included). Your holding starts with a cost basis of $5,000.

The company splits ten-for-one. So your original cost basis of $50 per share is divided by ten to $5 per share. However, you also received ten shares of stock for every one share you had. Thus, you now have 1,000 shares of the company’s stock at $5 per share for a cost basis of $5,000.

Then, you sell 200 shares. The cost basis of the 200 shares is $5 per share for a total of $1,000.

The remaining 800 shares keep their cost basis of $5 per share for a remaining cost basis of $4,000.

In the early days of our business, it was very common for clients’ cost basis record to be lost or corrupted. We had to do research back in their financial statements in order to try and estimate a cost basis for them. Selling a security before correcting their cost basis might mean a capital gain of 100%, and as a result, very costly capital gains taxes.

In 2010, the government began requiring brokerage firms to keep track of the cost basis of each trade lot. They also require them to transfer that information to other brokerages whenever a security is transferred.

Now, it is rarer to find a client who has missing cost basis, but every now and again we still have someone. The process of correcting cost basis problems, although time consuming, is worthwhile as it allows you to reduce taxes owed when a security is sold.

Photo by Ashraf Ali on Unsplash. This post appeared on Krisan’s Backoffice, Inc in its original version on August 11, 2011. It has been edited and reprinted here with permission.