The taxpayer deserves a tax-free "Recovery"
Basis (or cost basis), as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays/(saves) taxes on a capital gain/(loss) that equals the amount realized on the sale minus the sold property's basis.
The taxpayer deserves a tax-free "recovery" of the cost of acquiring a capital asset, because this cost is analogous to a "business expense" used to acquire income. This recovery is postponed to the year of disposition because of a further analogy to the accrual accounting principle of matching expenses to revenues: disposing of property will deprive the taxpayer of a valuable asset, leaving a "hole" that should be filled by some form of tax-free recovery. The size of this "hole" is set to equal that asset's original cost, but doing so is not logically necessary; rather, it arises from the administrative decision to levy income tax on asset appreciation at the moment of sale, rather than as it appreciates (in which case, basis would equal amount realized and there would be no tax at disposition -- since appreciation taxes were levied by constant assessments).
From Publication 551: "Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property."
For federal income taxation purposes, determining basis depends on how the asset in question was acquired.
Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals the purchase price. See IRC § 1012.
Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred basis (also called carryover basis). See IRC § 1015. Put simply, gifted assets retain the donor's basis. This means that the value of the asset at the time of transfer is irrelevant to computing the donee's new basis. The general rule does not apply, however, if at the time of transfer the donor's adjusted basis in the property exceeds its fair market value and the recipient disposes of the property at a loss. In this situation the asset's basis is its fair market value at the time of transfer. See Treas. Reg. § 1.1015-1(a)(1).
Assets acquired by inheritance: Assets acquired by inheritance receive stepped-up basis, meaning the fair market value of the asset at the time of the decedent's death. See IRC § 1014. This provision shields the appreciation in value of the asset during the life of the decedent from any income taxation whatsoever.
Adjusted basis: An asset's basis can increase or decrease depending on changes that occur throughout its lifetime. For this reason, IRC § 1001(a) provides that computing gain requires determining the amount realized from the sale or disposition of property minus the adjusted basis.
Capital improvements (such as adding a deck to your house) increase the asset's basis while depreciation deductions (statutory deductions that reduce the taxpayer's taxable income for a given year) diminish the asset's basis. Another way of viewing adjusted basis is to think of the asset as a saving's account, with capital improvements representing deposits and depreciation deductions representing withdrawals.
Mutual Fund Basis Methods
For mutual funds, there are 4 basis methods approved by the IRS, detailed in Publication 564:
Cost basis methods:
Average basis methods:
- Specific share identification
- First-in, first-out (FIFO)
- Average cost single category (ACSC)
- Average cost double category (ACDC)
Evaluation of methods
Specific share identification is the most record and labor intensive, as one must track all purchases and sales and specify which share was sold on which date. It almost always allows the lowest tax bill, however, as one has discretion on which gains to realize.
FIFO is the default method used if no other is specified, and generally results in the highest tax bill, as it sells oldest (hence generally most appreciated) shares first.
Average cost single category is widely used by mutual funds, as it is the simplest in terms of record keeping (only total basis need be tracked) and sale (no specifying required), and results in moderate tax.