Buying stocks that pay regular dividends and reinvesting those dividends is a good way to build equity, and it does add to the cost basis of your stock. Correctly tracking the basis of your stock is important because you don’t pay taxes on the basis when you eventually sell the shares. If you figure the basis incorrectly, you could end up paying taxes twice on the same money.
Cost basis, also called tax basis, is the amount of money you spend to make an investment. Stock cost basis includes the purchase price of the shares and any fees or commissions you pay for the transaction. For example, if you buy 100 shares of XYZ Company at $20 per share and pay your broker a commission of $50, your cost basis is $2,050. When you sell the shares, you subtract the cost basis from the sale proceeds to calculate your capital gain or loss for tax purposes.
Many companies offer dividend reinvestment plans, or DRIPs, to encourage stockholders to keep investing. Dividends are used to buy more shares instead of being sent to you. You must report the dividends on your tax return and pay taxes on them. As far as the Internal Revenue Service is concerned, it’s as if you received the dividends in cash and sent money back to buy more shares. Your cost basis increases by the amount of money used to buy the stock. The fact that the money started as a dividend payment makes no difference.
Again, suppose your cost basis to buy XYZ Company stock was initially $2,050. The company has a DRIP and does not charge any fees for stock purchases through the plan, so all of your dividend payments go to buy more stock. The stock earns $100 per year for the next three years, for a total of $300. Your cost basis is now $2,050 plus $300, or $2,350. You’ve paid income taxes on the dividends each year. If you sell the shares and report only the original cost basis of $2,050, you’ll pay taxes on the $300 in dividends a second time.
More often than not, the stock’s price does not divide evenly into the amount of a dividend payment. For instance, if a stock is selling at $30 per share, a $100 dividend will buy three whole shares and you have $10 left over. Companies that offer DRIPs typically credit you with a partial share, so every penny of the dividend goes to buy stock and adds to your cost basis. However, if you have a dividend reinvestment plan through a brokerage firm, this may not be the case. Brokers often don’t like to deal with fractional shares. In this situation, the money left over after buying whole shares is credited to your account. Since this money is not used to buy shares, it does not add to your cost basis.