Basis is the amount of your investment in property for tax purposes. While the meaning of the noun Basis may seem as simple as the word “Cost” in everyday conversation, the tax code doesn’t make it quite that simple. Specifically, it is important to know at least three of the major tax terms, their meanings and how they can help or hurt you: Cost Basis, Adjusted Basis and Specially Determined Basis.
Cost basis is generally the amount you pay for property in cash, debt obligations, other property or services. Your cost could also include the following items:
Installation and testing,
Certain miscellaneous related costs associated with the purchased item.
Prior to determining whether you have a gain or loss on the sale of property, you must know what your adjusted basis in that property is. Adjusted basis, unlike historical cost, can increase or decrease for a variety of reasons.
Increases in Adjusted Basis. The adjusted basis of property increases by the cost of items having a useful life of more than one year that you purchase and add to the property.
Examples include but are not limited by:
Putting an addition on your home
Replacing an entire roof
Paving your driveway
Decreases in Adjusted Basis. The adjusted basis can also go down. This can happen for a number of reasons, more common with business assets than with personal assets.
Examples include but are not limited by:
Specially Determined Basis
There are dozens of different specially determined basis situations. Some, like third-party intermediary involved Section 1031 exchanges can be extraordinarily complex requiring attorneys, accountants, appraisers and other experts in the field. Many others are less complex. Due to limited space, we will introduce you to just three of these which you are most likely to encounter in everyday life.
Property Received as a Gift. Did you know that if you receive property as a gift that you may have to keep track of two different values? It’s true. The tax code has a rule that states that if you receive a gift you must know its adjusted basis in the hands of the owner that gives the gift to you and also the fair market value of the asset at the time you receive it. This is because the tax code states generally that if you turn around and sell the gift you received, your basis for figuring a gain is the same as the donor’s adjusted basis. But, if you sell the gifted property for a loss, generally your adjusted basis is the fair market value.
Example. In 2012, Aunt Elda gives you 5 acres of land that she bought in 1960 for $500. You had the land appraised and it appraised for $5,000 an acre in 2012 when you received it. You made no improvements on the land and in 2014 you sold the 5 acres for $6,000 an acre or $30,000. How much gain do you have to pay tax on?
Sales Price of 5 Acres Times $6,000 Per Acre
Aunt Elda’s Adjusted Basis in all 5 Acres
Common sense might make you think that you would only have a $5,000 gain on the sale ($30,000 Sales Price - $25,000 Fair Market Value at Date of Gift) but unfortunately, that would be incorrect. Hopefully, you will know what the rules are before making a potential decision like this.
Inherited Property. Property that is inherited is generally given a special basis which is the fair market value at the date of the individual’s death. There are many special variations of this rule which is beyond the scope of this article but the general rule is inherited property’s basis is the fair market value at the date of the decedent’s death.
Discovered Objects. What if you find 17th century buried pirate’s treasure?
Unfortunately, you have to pay tax on the fair market value of the treasure when you take ownership of it.
But, as a consequence of paying the taxes, you get a basis in the treasure. For how much? The fair market value of the treasure when you took ownership of it, since that was the amount you had to include as income.
Basis is one of the key concepts in the tax code, which means there are a lot of rules, sub-rules and exceptions to exceptions.
At the Tax Reduction Letter, we have 272 articles discussing basis. What if none of those articles apply to your unique situation? Send us an email and we will write an article on that issue. Try the Tax Reduction Letter free today.