If you buy a house for $100,000 and sell it for $150,000, how much income do you have?
If you said $50,000, you are correct. You can break down the $150,000 sale price into two parts:
$100,000 – the money you put into the house
$50,000 – the increase over the money you invested
Next question – how much of the $150,000 do you have to report on your tax return?
Thankfully, the answer for tax purposes is also $50,000.1 You pay income tax only on the increase, if any, from the money you invested in the property.
The tax code uses the term “basis” (or “tax basis”) to describe the amount of money you invest in property.2 The increase or decrease from that investment is “gain” or “loss.”
How Basis Helps You
Basis ensures that you only pay tax once on your income.
Think about it this way. When you bought the house, you did so by using money you earned in your business, money you already paid taxes on. In other words, you bought the house with after-tax income.3
If you had to pay tax again when you sold the land, the IRS would be taxing you twice on the same income.
Losses. Suppose the value of your investment decreases. Instead of selling the house for $150,000, you sell it for $75,000.
This time you lose money on the investment. If the house is a business asset, you can use the loss to offset your taxable income by $25,000 ($100,000 - $75,000).4
Thus, in a way, you recover the taxes you paid on the $25,000 that you lost in the investment.
Adjustments to Basis
Basis can go up or down over the course of your ownership of the property.
For example, suppose you build a garage for the house, or you add a pool, which costs you $20,000. Since these are permanent improvements to the house, you increase your basis by the amount you spent.5
Therefore, your basis increases from $100,000 to $120,000.
So when you sell your house for $150,000, you only have $30,000 of gain ($150,000 - $120,000).
Decreases in Basis. Just as basis can go up, it can go down. This can happen for a number of reasons, more common with business assets than with personal assets.
You reduce basis, for example, when you depreciate business assets. With depreciation, you take a deduction each year for the asset’s deemed loss in value. (Also see amortization.)
When you depreciate an asset, you must reduce the asset’s basis by the amount of the deduction. That way, if you resell the asset, your adjusted basis accurately reflects the money you have spent on the property (and the money you have taken back through tax benefits).
Special Basis Rules
Money can come to you in a lot of different ways, such as through your job, through inheritance, through gift, or even pure luck.6 This affects your basis in the property.
Gifts. If you receive property as a gift, you take the basis the donor had in the gift at the time you received it.7
Inheritance. Your basis in inherited property is the fair market value at the time of the owner’s death.8
The inheritance rule is a big tax benefit.
For example, suppose that your grandparents purchased stock at $20 a share, and, many years later, you receive the stock through inheritance when it is worth $1,020 a share. Under the inheritance rule, you could sell the stock for $1,020 a share and pay nothing in taxes. (Your grandparents would have paid taxes on $1,000 a share: $1,020 minus their basis of $20.)
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.9
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.
1 IRC Section 1001(a). Technically, you realize $50,000 of gain for tax purposes, but you may not have to put that income on your return. See, e.g., IRC Section 1031.
2 See IRC Section 1012; IRS Publication 551, “Basis of Assets.”
3 If you used a loan to buy the house, the analysis does not change, since you are obligated to repay the loan with after-tax money in the future.
4 The tax code restricts the use of losses in many ways. Whether you will be able to take advantage of the loss in the current year depends on other provisions in the code.
5 IRC Sections 1011; 1016.
6 Unfortunately, money can leave you in a lot of different ways too. Our mission at the Tax Reduction Letter is to be sure you lose as little as possible in the form of taxes.
7 IRC Section 1015(a). If the gift’s fair market value at the time you received the gift was less than the donor’s adjusted basis, you have to use the fair market value as the original basis when determining loss.
8 IRC Section 1014(a).
9 Reg. Section 1.61-14(a).