Figuring the Correct Investment Cost Basis

No one wants to pay the same tax twice, but that's exactly what a lot of people do when they don't correctly figure the cost basis of the stocks or mutual funds they sold.This is a particular concern if you reinvest dividends and capital gains distributions rather than taking the earnings in cash. These transactions increase the basis, or tax value, of your investment.

The basis amount is crucial in determining any capital gains tax bill you owe when you sell your holdings. It also could add to any capital gains tax loss you want to use.

Adding up All of Your Investments

Generally, you subtract the price you paid for an asset from its sale price to arrive at your taxable basis. However, reinvested earnings affect basis. Here's how it works.

You bought 100 shares of a stock for $1,000 in 2008 and that year had dividends of $100 reinvested. In 2009, you got another $200 in dividends and capital gains distributions, again reinvested.

Tax law considers these reinvested earnings as paid to you even though you didn't actually have the cash in your hand. The Internal Revenue Service says the earnings were "constructively received" by you, meaning the money in your account belonged to you and you could have taken it out if you wished. These earnings are reported on Form 1099-DIV and you must pay taxes on the amounts in the years you receive them.

Last year, you sold all your stock for $1,500. Here's where your reinvested dividends can help reduce your taxable gains.

Take your $1,000 original purchase price and add the $300 that you reinvested -- and already paid tax on -- when you filed your 2008 and 2009 returns. This gives you an adjusted cost basis of $1,300. This is the amount you subtract from your sale price of $1,500, meaning you have taxable gain of only $200 instead of $500.

If you don't account for reinvested distributions, you'll end up giving Uncle Sam tax money a second time when you sell.

Losing the Loss Value

And if you're looking to take advantage of a capital loss to reduce other gains, a wrong basis amount could cheat you out of the full benefit of that tax advantage.

For example, let's say in the scenario above you sold your stock for $800, thinking you'd use the capital loss to offset gains you made on another holding. However, you're not getting the best possible tax loss unless you take into account your reinvested earnings.

If you simply subtract your original investment of $1,000 from your sale proceeds of $800, you get a $200 loss. Your true loss is larger.

That extra $300 in losses could make a difference in your final tax bill.

Complete Records Mean Correct Basis

To make sure you don't overpay the IRS on your investment gains or lose out on a valuable tax-loss deduction, hang on to all your stock and fund account statements.

These documents will show you exactly how much in additional purchases, either directly or with reinvested funds, you made during the life of your account. The statements also should reflect any fees and charges you paid to acquire or redeem fund shares. While these amounts are not deductible, the IRS says you can usually add them to your cost of the shares and thereby increase your basis.

The paperwork collection may mean an extra folder in your filing cabinet, but it will help you figure the correct cost basis to calculate a capital gain or loss. And that could mean extra cash in your wallet at tax time.