Cost basis is an important element of every investment you own, as it helps determine whether you'll have a taxable gain or loss when you sell. But many investors get confused about how dividends -- whether they be stock dividends or cash dividends -- affect cost basis. Let's take a closer look at the question to get you the answers you need to know.

What is cost basis?
The cost basis of an investment is the total cost of that investment, including the amount spent to purchase it, any commissions or fees associated with that purchase, and any other related costs. For tax purposes, the cost basis of an investment can be reduced by certain items, but only rarely. Most common (for businesses) are depreciation and depletion (e.g., oil, timber, minerals depletion allowances).

Accounting for cost basis reveals the true returns of investments, as high commissions or fees, either from high fee structures or frequent trading, reduce the net returns of the investment.

What dividends do to cost basis
Different types of dividends have different effects on cost basis. Cash dividends do not lower the cost basis of an investment, either when you actually receive cash or when you use the proceeds to purchase new shares. A stock dividend, however, does adjust cost basis, as does a "return of capital."

As an example, suppose you buy 37 shares of a company at $45. Your broker charges you $7.99 in commissions to handle that transaction for you (hey, they gotta eat too). What is your total cost, or basis?

Easy. 37 x $45 + $7.99 = $1,672.99. This works out to be $45.216 per share.

Cash dividends, as noted, do not reduce your basis, despite what the historical price section on Yahoo! Finance indicates (that's just to make it easier to calculate what total returns would be including reinvested dividends). However, splits and stock dividends do. For an example of the latter, see the dividends page.

For a split (like 3:2 or 2:1 or 3:1), you increase the number of shares by the split factor, which necessarily reduces the per share cost basis. Suppose that stock you purchased above splits 3:1. Your new basis would be $1,672.99 / 111 shares = $15.072 per share, now. (But your total basis, $1,672.99, remains the same.)

As confusing as cost basis can be, dividends don't have to be overly intimidating. As long as you remember which types of dividends affect basis and which don't, you'll be in the best possible shape to handle tax issues when the time comes.