Tax basis determines the profit or loss from selling an asset.
Taxable Gain or Deductible Loss = Net Sales Proceeds – Tax Basis
A business is taxed on its net income, which is the difference between gross income and expenses. Because a business has many expenses, it must fill out tax forms listing those expenses in categories, so that the IRS can determine whether the expenses in those categories are reasonable compared to other comparable businesses.
However, many taxpayers earn income from the sale or disposition of assets that are not related to a particular business. Nonetheless, they will have expenses in either acquiring or disposing the asset, such as sales commissions, sales taxes, and marketing costs. Businesses will also have certain expenses related to particular assets. Tax law permits taxpayers to deduct these expenses indirectly, by adding the expenses to the tax basis of the asset, which is subtracted from the value received in the disposition of the asset to compute net taxable income. This negates the need to fill out a complex tax form to calculate a taxable gain or deductible loss, as a business must do to figure its income or loss. The tax basis obviously includes the purchase price of the asset, which is usually the major portion of the tax basis. Because the tax basis is adjusted by capital improvements, depreciation, and acquisition and selling costs, tax basis is also often referred to as the adjusted basis, because the tax basis may change during ownership.
The tax basis of any asset may be determined by:
- the asset's cost;
- its fair market value;
- reference to the basis of another asset, such as a nontaxable exchange, where the new item acquires the carryover basis of the replaced item; or
- the basis of the asset to another taxpayer, such as the receipt of a gift.
When property is converted from personal use to business or income-producing use, then the basis for loss on the converted assets is the lower of the property's adjusted basis or it's fair market value on the date of conversion. However, the gain basis remains the property's adjusted basis on the conversion date, because gain is always recognized whether the property is personal, business, or investment related.
The purchase price of an item is usually the largest component of the basis for most property. State and local taxes, and installation and shipping charges can also be added. If it is a business asset, then any depreciation claimed on the property in prior tax years must be subtracted.
Example — Buying and Selling Stock
You buy $1000 worth of stock and pay your discount broker a $4 commission. You later sell the stock for $1100 and pay another $4 commission to your broker. The $8 of commissions is added to the basis of your stock, giving you a tax basis of $1008. Therefore:
Net Taxable Income = $1100 - $1008 = $92
Of course, since you only actually received $1096 for the sale of your stock, you could have just subtracted your tax basis of $1004 previous to the sale from the sale proceeds to arrive at the same answer.
Often, the tax basis must be adjusted because of improvements to the property or because the property was depreciated. Adjusted basis is the means by which certain expenses for assets can be deducted. Being able to adjust the tax basis because of improvements to the property allows a taxpayer to deduct those expenditures when the property is finally disposed of.
Example — Tax Basis in Real Estate
You paid $120,000 for a house and paid an additional $10,000 to renovate the bathroom. The $10,000 is added to the tax basis of $120,000 to yield an adjusted basis of $130,000. So if you later sell the house for $160,000, then your net income will be $30,000 minus the brokerage commission you paid to sell your house. You can also depreciate your house over 27.5 years. However, because land cannot be depreciated, only the fair market value of the house itself can be depreciated, not the land. However, the total depreciation claimed for the property must be subtracted, adjusting its basis downward, which will increase the amount subject to tax when the property is sold.
Since many assets have a lifetime greater than 1 year, tax law permits individuals or businesses to depreciate such assets over a duration, allowing them to deduct a certain percentage of the property each year until the full cost of the property is deducted. IRC §167
However, if the asset is disposed of before it is fully depreciated, then the taxpayer will have to either report taxable income or take a loss on the property, which will depend on the difference between the sale price and the tax basis of the property at the time of the sale. If the sale price is greater than the tax basis, then there is a net taxable income that must be reported. The income may be taxed as a capital gain or as depreciation recapture, or a combination thereof. If the sale price is less than the tax basis, then the business can subtract that loss from its income. As property is depreciated, its tax basis is decreased annually by the amount of the tax deduction taken on the property. So if the property is fully depreciated, then its tax basis is zero.
Transferred Basis of Gratuitous Transfers
A gift has what is called transferred basis, the same tax basis as the donor of the gift had, plus any gift tax that was paid for the gift by the donor (IRC §1015). If gift tax was paid, then the basis is adjusted accordingly:
Net Appreciation of Gift = FMV of Gift When Given – Donor's Adjusted Basis
The tax code defines a basis increase as being a ratio equal to the base increase over the gift tax paid that would be equal to the net appreciation of gift divided by the value of the gift after subtracting the annual exclusion that was applicable when the gift was made.
Gift Tax Paid
|=|| Net Appreciation of Gift |
– Annual Exclusion Applicable When Gift Was Made
Solving for the basis increase yields the following:
|Basis Increase||=|| Gift Tax Paid × Net Appreciation of Gift |
– Annual Exclusion Applicable When Gift Was Made
Inherited property has a tax basis equal to its fair market value (FMV) when the donor died or on the alternative valuation date 6 months after death, if that date was chosen by the personal representative of the estate, by filing Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent. Because many assets, such as real estate, tend to appreciate, this leads to an increase in basis, referred to as a stepped-up basis, but some assets do decline in value with age, so the term stepped-up basis is sometimes a misnomer (IRC §1014). This stepped-up basis results from the fact that the property was either taxed as part of the estate or was exempt. The legal rationale for giving estate property a stepped-up basis is that it would be subject to double taxation. Instead, a large unified tax credit allows most gratuitous transferred property is escape taxation, a major boon to the wealthy. However, property that was inherited from 2010 estates may not receive a stepped-up basis, if the personal representative chose that option, since there was no estate tax for that year. Nonetheless, the rules for determining basis for gifted property is more complex, depending on the sale price of the property and the FMV, as shown in the following table:
Summary of Rules for Determining Carryover Basis for Gifted Property
- If Sale Price > Donor's Basis and FMV, then
- Donee's Basis = Greater of Donor's Basis or FMV
- Else If Donor's Basis < Sales Price < FMV or
- Else If Sale Price < Donor's Basis and FMV
- Donee's Basis = Lower of Donor's Basis or FMV
Note that basis will also be adjusted by depreciation or capital improvements or other adjustments to basis, depending on the type of property and what adjustments were made by the donee.
The personal representative reports the basis of the property to both the beneficiaries and the IRS on Schedule A in Form 8971, Information Regarding Beneficiaries Acquiring Property from a Decedent, if the estate was large enough that a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return was filed.
Basis Consistency Requirement for Inherited Property
There is a formal basis consistency requirement for inherited property reported on estate tax returns filed after January 31, 2015. To ensure that the basis reported by the estate and by the beneficiaries of the estate are the same, the personal representative of the estate must file Form 8971, Information Regarding Beneficiaries Acquiring Property from a Decedent, which includes Schedule A, within 30 days when the estate tax return was filed, or if earlier, within 30 days of the filing due date with extensions. Otherwise, the personal representative may be subject to penalties for failure to file timely and correct Forms 8971 and Schedule A's. Schedule A is filed for each beneficiary, with one copy going to the IRS and the other copy going to the beneficiary.
This reporting of basis is not required if the value of the estate property is below the value required for a filing of the estate tax return. Certain gross estate property is exempt from this reporting, including: cash, income in respect of a decedent, small items of tangible personal property that would not ordinarily require an appraisal, and property sold by the estate rather than being distributed to the beneficiaries.
A failure to use the reported basis when reporting a gain or loss from the sale of the property will incur a 20% accuracy-related penalty, assessed on the beneficiary.
Exchanged Basis of Property Exchanges
When taxpayers trade property at arm's length, they tend to trade property of equal value. Hence, the tax basis of the property often has the same tax basis as the property exchanged — what the IRS calls exchanged basis. Substituted basis is a more general term that can refer to either transferred basis or exchanged basis. IRC §7701
When something is received as barter, then the received item has the same tax basis as the bartered item in the same way that an item purchased with cash has a tax basis equal to the amount paid.
When an asset is exchanged for another asset of like kind, the tax basis in the acquired property is the same as the tax basis in the exchanged property, which is called substituted basis. However, substituted basis only applies to like-kind exchanges. For instance, real estate must be traded for real estate, and tangible property must be traded for tangible property. If the exchange is not considered of like-kind property, such as exchanging tangible property for intangible property such as a trademark or copyright, then the IRS treats the exchange as a sale of one item followed by the purchase of the other. Nonetheless, the tax basis in the exchanged items would probably be equal in an at-arms-length transaction, since people tend to exchange items of what they considered equal value.
When exchanged items are accompanied by cash payments or a service, then the additional consideration changes the tax basis of the exchanged items. When an item is exchanged for another asset plus cash, then the tax basis of the acquired item is the tax basis of the old exchanged item plus the amount of money that was paid, which is often called boot. If the taxpayer receives an asset plus money, then the tax basis in the asset is equal to the tax basis of the previous owner reduced by the amount of cash paid. If the taxpayer exchanges a good for a service, then the tax basis of the good is equal to the fair market value of the service.
When a personal asset is converted into a business asset, then the tax basis of the converted property is the fair market value on the date of conversion or the adjusted basis in the property, whichever is lower.
Additional special rules:
- If the donee receives property back from the decedent that was gifted by the donee or his spouse within 1 year before death, then the basis will equal the basis — not the FMV — immediately before the decedent's death, which will usually be the donor's original basis. This rule prevents donors from giving gifts to people who were expected to die soon to receive a stepped-up basis in the gift.
- If, under the will, a beneficiary only receives the right to purchase the property, then the basis will be the purchase price.
Brokerage firms must report to the taxpayer and to the IRS the cost basis, which is the cost of the securities plus brokerage fees, of any securities purchased in 2011 or afterward. Cost basis is equal to the tax basis if there were no other expenses in purchasing the securities. Brokers are required to send Form 1099-B, Proceeds From Broker and Barter Exchange Transactions to the taxpayer to report their calculation of the taxpayer's cost basis.
Individual market transactions must be listed on Form 8949, Sales and Other Dispositions of Capital Assets, then capital gains and losses must be figured on Schedule D, Capital Gains and Losses. The IRS uses a default method of "first-in, first-out" for securities. However, the taxpayer can change this by specifically identifying the securities sold by specifying when they were purchased. If the adjusted basis is incorrectly stated on Form 1099-B, then the taxpayer should notify the broker to have a new Form 1099-B sent, with the correct information. This new reporting requirement will affect mutual funds, exchange traded funds, and dividend reinvestment plans in 2011; other securities will be included in later years.