Basis for Tax Purposes
Basis is a term used in computing gains and losses on the disposition of an asset. For any business owner or individual taxpayer it is important to understand what the Internal Revenue Service (IRS) is really seeking. What is your tax basis in an asset? With a simple transaction such as purchasing stock, assume you paid $300 for a single share of stock. All $300 came from your cash that you earned from your job and you have paid your income taxes on that $300. Then, your basis is $300. When you sell this stock, the difference between the sales price and the basis is your taxable gain or taxable loss.
To fully understand basis, the reader should understand some basic principles of basis. Then, I’ll explain how basis is computed based on the various forms of acquisition of the asset. Once the basis is acquired, it is sometimes adjusted due to various additions and reductions. This affects the computed gain or loss. The following sections explain this basis formula in more detail and provide some examples to help the reader gain a better understanding of basis for tax purposes.
Some Preliminary Information
The most important rule is that basis is calculated based on the law in effect at the time of sale or disposition. For the sake of this article, the term disposition will be used and it includes the concept of a sale.
This is why the taxpayer needs to understand that there are basis adjustments at the time of disposition. The basis is subtracted from the value gained in the disposition to determine the gain or loss. Once the gain or loss is determined, the gain or loss is classified into the different types of income and the tax rates for those types of income are then used to determine the actual final tax due. The following are the various types of income or losses:
For the reader, the most likely applicable types of gains or losses relate to ordinary and capital. The other forms require more background knowledge and business sophistication (years of education) to fully understand. This article is oriented towards the basic principles of basis.
Ordinary income is typically taxed at a higher rate than capital gains. This is not necessarily true for individuals earning less than approximately $75,000 per year due to the rate schedules involved. In general, for those married couples making less than $75,000 per year, all income whether ordinary or capital is pretty much taxed at the 15% rate. There are some opportunities for capital gains at 0% for this group but the formula gets a little complicated and this subject is for a different article; suffice it to say that both forms of income are taxed at 15%.
Taxpayers earning more than $75,000 have two distinct rates. The primary form of income is ordinary which is taxed at a 25% rate while capital gains are taxed at 15%. It is in this group of taxpayers that understanding basis comes in handy.
Determining Basis at Acquisition
There are four primary methods of acquiring property. Each has its own unique attributes of determining basis. The following four subsections explain the four different acquisition methods and their respective attributes.
Purchase of Property
The most common property acquisition method is a direct purchase; most often a cash purchase. You see this daily in the stock market. In the traditional purchase method, the basis is equal to the actual cash paid for the item plus any cash paid for settlement and or other fees associated with the purchase. Here is an example:
Taxpayer purchases a home for $150,000 using a cash down payment of $25,000 and borrowing the balance from a mortgage company. At closing, the taxpayer pays fees of $7,000 related to points and legal fees. Therefore, the total basis in the property is $157,000.
Over time, the basis may increase related to other types of fees or improvements to the property. In the example above, if the taxpayer adds a new living room to the house for $33,000; the new basis is $190,000.
Sometimes, the basis must be reduced related to the property. The most common basis reduction method in business is depreciation. As the property is used in business; tax depreciation is claimed as an ordinary expense and therefore the basis of the related property is also adjusted. Other forms of basis reductions include tax credits for the respective property and the most recent required cancellation of debt, Form 1099-C. The following is an example for a small business:
Jim’s construction company bought a used pickup truck for $17,000. He uses MACRS to depreciate the vehicle over five years. By the end of the second year, Jim has taken $8,840 of depreciation and therefore the remaining basis of the truck is $8,160. Please note, the depreciation is an ordinary income tax deduction so therefore any gain at time of disposition will be tax at the ordinary rates.
Acquisition via Exchange
One of the more common forms of exchanges relates to a taxpayer exchanging an asset for stock in a small business. Many of these exchanges are tax free under Code Section 351 due to the control issues. In these situations, the basis of the stock is equal to the basis of the asset exchanged. Sometimes though, the taxpayer adds cash which is also termed ‘Boot’ in the deal. In this situation, the basis is equal to the basis of the asset in the hands of the purchaser plus any boot in the deal.
Another form of exchange occurs with the trade of an existing asset for a similar asset. In this situation, the basis is carried over from the traded in asset. Sometimes the newer asset requires additional cash to make the deal work. Here, basis is equal to the basis of the trade plus any boot as illustrated in the stock example above. Let’s continue the truck example above and Jim’s trades in the vehicle for a newer model.
After two years, Jim decides he wants a newer model of the same kind of truck. The dealership agrees to take as a trade the existing truck and gives Jim credit for $8,160. The newer truck costs a total of $19,400. Therefore Jim must pay $11,240 as boot in the deal. Jim’s new basis in the new truck is equal to $19,400.
But suppose the dealership only gives Jim $7,000 as his trade in value. Now Jim must add boot of $12,400 and his new basis in this asset is again $19,400. Let’s flip this the other way, and the dealership gives Jim $10,000 of value for the trade. Jim pays $9,400 of cash (Boot) in the deal. Jim’s new basis is equal to his old basis of $8,160 plus the boot of $9,400 for a total of $17,560. Basically Jim is deducting the gain from the original asset disposed ($10,000 – $8,160 of basis) of $1,840 from the value of the new truck. Therefore, $19,400 minus $1,840 equals $17,560.
Gift or Inheritance
When property is given to a taxpayer, the basis of the property given is equal to the basis as held by the donor. Most often gifts are from parents or grandparents to the child. The done (child) needs to know the basis of the gift in order to properly record the information to accounting records of the business. I often see the parents donate a vehicle or some piece of equipment they owned to the business as owned by the taxpayer. This gift is recorded on the books at the basis of the donor; so it is important to ask. If the donor doesn’t know the answer, then the done should document the fair market value and exchange a thank you note recognizing this value.
The other form of a gift is via death. This is the most common form of transfer of property in families. Unlike a gift, the inherited property receives a set-up in basis at the time of death of the decedent. Therefore, the property received has a basis equal to the fair market value at time of death. This is big in business as it resets the value of the assets in a small business when the owner dies and transfers the business to his children. This is one the primary tools of wealth transfer in the United States.
Other Forms of Acquisition
Other forms of acquisition include receiving property by transfer in trust. In general, the basis is equal to the basis held by the grantor plus any recognized gain or loss if applicable at the time of the exchange. A second other form of acquisition is receipt of property related to services rendered for an employer. In this case the property’s basis is equal to the fair market value of the acquired asset contingent upon the taxpayer recognizing the value as income on his tax return.
A third other form of acquisition is property transferred between spouses. In this situation, the transfer is typically driven by a divorce decree and therefore the recipient’s basis is the same basis as held by the original party.
The acquisition basis is used as one element in determining total basis. But total basis is needed until the time of disposition. Basis is adjusted at the time of disposition for several different reasons and the following section explains this in more detail.
Basis Adjustment at Time of Disposition
There are two methods of disposition. The most common is the traditional sale of the asset and the rarely used exchange of the asset. This section explains these two methods and how the basis is adjusted to determine total basis.
Sale of an Asset
When an asset is sold the basis is adjusted related to the costs of the sale. A good example relates to the sale of real estate. The seller hires a broker and at the time of closing, there are a multitude of additional costs and fees related to the exchange. These fees and costs are added to the existing basis for the total basis. The total basis is used to determine the gain or loss related to the sale. Other types of adjustments at time of sale include:
- Recapture – when a business asset is disposed, any depreciation taken to date that exists as the difference between the realized amount from the sale and the existing basis is recaptured. This recaptured value is added to the existing basis to increase the basis for calculating the capital gain on the sale of the asset. Recaptured amounts are taxed at ordinary rates because when the depreciation was taken, the tax savings were ordinary.
- Broker Fees – fees or charges related to the transaction for the sale of investments (stocks, bonds, mutual funds, etc.).
- Taxes – in some transactions there are grantor or property exchanges taxes, these taxes paid by the seller are added to the basis to determine gain.
- Auctioneer and Other Professional Fees – auctioneers charge around 15% of the sales to cover their marketing and operational fees related to the sale of goods. In other cases, professionals are involved in the transaction and include attorneys, engineers and accountants. These fees are added to the basis of the sold asset.
- Recording Fees – many business and real estate transactions require recording in the circuit court, these fees are added to the basis of the asset sold and or purchased depending on the paying party.
Exchange of an Asset
This is the most complicated of all dispositions due to the tax code complexity involved. The IRS requires the basis be recorded correctly in the exchange. Often exchanges involve more than just a simple ‘I’ll give you my 2000 Pickup Truck for your 2000 Pickup Truck’. Basis adjustments include the costs associated with these exchanges and of course there are ‘Boot’ issues too. In the case of an exchange, please consult with your accountant to determine the basis of the asset received in the exchange.
Exchanges are both voluntary and involuntary and include some of the following:
- Involuntary Conversion – often the government or some large utility company requires some of your land for capital improvements. The tax basis is adjusted related to the portion of the asset converted. Again, talk with your CPA about this.
- Stock Merger or Spin-Off’s – if you are actively involved in the market, every now and then you’ll get a letter explaining how your stock investment is either spinning off a division or merging with another company. There are stock for stock exchanges, cash payments and combinations of both for these transactions. The basis is sometimes adjusted related to your portion and is affected by several different issues. Again, talk with your CPA about these transactions.
- Tax-Free Exchanges – there a several different types of tax free exchanges, most of them deal with stock for other valuable assets or stock for stock and so on. In real estate, there is section 1031 exchanges whereby one piece of real estate is swapped for a similar piece of real estate. These are generally more sophisticated transactions and it is best to let a CPA address the nuances involved.
Now that you have disposed of the asset, the simple formula is: Realized Value less Basis equals Gain or Loss. The following section explains this a little more.
Calculating Gain or Loss
Often the business calculation process for a gain or loss is different than a tax calculation. As an example, in a real estate transaction, the term ‘Adjusted Sales Price’ relates to the contract price less any allowances and fees paid to dispose of the real estate. With taxation, the IRS uses the term ‘Realized Amount’ which is essentially the contract price less any adjustments related to the contract value for the date of closing. Some real estate contracts may state that the price is $1,000,000 reduced by $250 per day for any closing date after a certain date. If the closing occurs two days later, the realized amount is $999,500.
In effect, the IRS wants to see the entire economic value of the sale as the primary line of information in the tax return. Any costs and fees are added to the basis of the asset disposed. Whereas in business, we often see several lines of information to reflect the business attributes involved. This is an example of a contractor’s report:
Contracted Sales Price $1,000,000
Compliance Cost (500)
Contract Price $999,500
Closing Costs (41,285)
Adjusted Sales Price $938,515
Costs of Construction:
Total Costs of Construction 761,696
Direct Margin $176,819
The direct margin line value of $176,819 is equivalent to our gain in a typical tax transaction. Notice in the business transaction, the term basis never comes up? But basically the basis equals closing costs, allowances and the direct costs of construction. The most common use of basis is in reference to the sale of asset in determining any capital gains or losses. But they are effectively the same thing.
Summary – Basis for Tax Purposes
Understanding basis for tax purposes helps all taxpayers no matter which tax bracket applies. The goal is to determine the correct gain or loss at disposition so that the proper type and amount of tax is paid to the Internal Revenue Service. Basis is determined based on the law in effect at the time of disposition. Basis has two elements. The first is the basis at acquisition and the second is any adjustment whether an increase or decrease at the time of disposition. Act on Knowledge.
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