Tax Basis

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, 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 unrelated to a particular business. Nonetheless, they will have expenses in acquiring or disposing of the asset, such as sales commissions, 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 asset's tax basis, which is subtracted from the value received from disposing the asset to compute net taxable income. Recording expenses as an increase in basis 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 includes the purchase price, 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, the tax basis is often called 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 (FMV);
• 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, the basis for loss on the converted assets is the lower of the property's adjusted basis or its fair market value on the conversion date. 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 is the largest component of the basis for most property. State and local taxes, and installation and shipping charges can also be added. For a business asset, depreciation claimed on the property in prior tax years must be subtracted.

The tax basis must often 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. Adjusting the tax basis for the costs of improvements to the property allows the deduction of those costs when the property is sold.

Since many assets have a lifetime exceeding 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}

If the asset is disposed of before it is fully depreciated, then the taxpayer must either report taxable income or take a loss on the property, which depends on the difference between the sale price and the tax basis of the property. If the sale price exceeds the tax basis, then the net taxable income 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. A fully depreciated property has a tax basis of zero.

Tax Basis of Gifts

The tax basis of a gift depends on more complicated tax rules (IRC §1015): it depends on the donor's tax basis, also called the transferred basis or carryover basis, or on the gift’s FMV when given. Whether the tax basis depends on the donor’s transferred basis or the gift’s FMV when given depends on whether the property was sold at a profit or sold for less than the FMV. The tax code specifies subtracting either the donor’s basis or FMV from the sale price so that the taxable income is minimized when the gift is sold for a profit but any deductible loss is also minimized if the gift is sold for less than FMV or the donor's basis. When sold at a profit, the greater of the donor's basis or the FMV is subtracted from the sale price; when sold at a loss, it is the lower of the donor's basis or FMV that is subtracted.

Note that basis will also be adjusted by depreciation, capital improvements, or other adjustments to basis, depending on the type of property and what adjustments were made by the donee.

How Gift Tax Affects the Tax Basis

If a gift tax was paid, which is rare, then a portion of the gift tax is added to the basis. Because of the unified tax credit and the gift tax annual exclusion, most gifts are not subject to gift tax. In the US, the donor is liable for the gift tax, not the beneficiary. A portion of any gift tax paid for the gift by the donor, equal to the gift tax attributable to the increase in the gift FMV over the donor's basis, is added to the transferred basis. So, if the donor’s basis is $500 and the FMV is $1,000, then the donee can add 50% of any paid gift tax to the transferred basis.

The increase in basis when a gift tax is paid for the gift is figured thus:

Solving for the basis increase:

Tax Basis of Inherited Property

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, often appreciate, this leads to an increase in basis, called a stepped-up basis, but some assets do fall 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 gifted or inherited property to escape taxation, a major boon to the wealthy.

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 its beneficiaries are the same, the personal representative of the estate must file Form 8971, Information Regarding Beneficiaries Acquiring Property from a Decedent, including 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 penalized for failure to timely file Forms 8971. Schedule A is filed for each beneficiary, with one copy sent to the IRS and the other copy sent to the beneficiary.

This reporting of basis is not required if the estate property value is below the value required for filing an 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
• property sold by the estate rather than being distributed to the beneficiaries

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 to the beneficiary.

Exchanged Basis of Property Exchanges

When taxpayers trade property at arm's length, they often 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 an exchanged basis. Substituted basis is a more general term referring to either a transferred basis or an exchanged basis. ^{IRC §7701}

When something is received as barter, then the received item has the same tax basis as the bartered item, like 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, called the 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 like-kind property, such as exchanging tangible property for intangible property like 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 be equitable in an at-arms-length transaction since people want to exchange items of 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 + cash, the tax basis of the acquired item is the tax basis of the old exchanged item + the amount paid, called boot. If the taxpayer receives an asset + money, then the tax basis in the asset = the tax basis of the previous owner reduced by the amount paid. If the taxpayer exchanges a good for a service, then the tax basis of the good = 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.

Historical Notes

Brokerage firms must report to the taxpayer and to the IRS the cost basis, which is the cost of the securities + brokerage fees, of any securities purchased in 2011 or afterward. Cost basis = 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 starting in 2011; other securities will be included in later years.

Property 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.