Article Highlights:
- Definition of Tax Basis
- Cost Basis
- Adjusted Basis
- Gift Basis
- Inherited Basis
- Record Keeping
For tax purposes, the term “basis” refers to the monetary value used to measure a gain or loss. For instance, if you purchase shares of a stock for $1,000, your basis in that stock is $1,000; if you then sell those shares for $3,000, the gain is calculated based on the difference between the sales price and the basis: $3,000 – $1,000 = $2,000. This is a simplified example, of course—under actual circumstances, purchase and sale costs are added to the basis of the stock—but it gives an introduction to the concept of tax basis.
The basis of an asset is very important because it is used to calculate deductions for depreciation, casualties and depletion, as well as gains or losses on the disposition of that asset.
The basis is not always equal to the original purchase cost. It is determined in different ways for purchases, gifts and inheritances. In addition, the basis is not a fixed value, as it can increase as a result of improvements or decrease as a result of credits claimed, business depreciation or casualty losses. This article explores how the basis is determined in various circumstances.
Cost Basis – The cost basis (or unadjusted basis) is the amount originally paid for an item before any improvements and before any credits, business depreciation, expensing or adjustments as a result of a casualty loss.
Adjusted Basis – The adjusted basis starts with the original cost basis (or gift or inherited basis), then incorporates the following adjustments:
- increases for any improvements (not including repairs),
- reductions for tax credits claimed based on the original cost or the cost of improvements,
- reductions for any claimed business depreciation or expensing deductions, and
- reductions for any claimed personal or business casualty-loss deductions.
Example: You purchased a home for $250,000, which is the cost basis. You added a room for $50,000 and a solar electric system for $25,000, then replaced the old windows with energy-efficient double-paned windows at a cost of $36,000. You claimed tax credits of $7,500 and $200, respectively, for the solar system and windows. The adjusted basis is thus $250,000 + $50,000 + $25,000 - $7,500 + $36,000 - $200 = $353,300. Your payments for repairs and repainting, however, are maintenance expenses; they are not tax deductible and do not add to the basis.
Example: As the owner of a welding company, you purchased a portable trailer-mounted welder and generator for $6,000. After owning it for 3 years, you then decide to sell it and buy a larger one. During this period, you used it in your business and deducted $3,376 in related deprecation on your tax returns. Thus, the adjusted basis of the welder is $6,000 – $3,376 = $2,624.
Keeping records regarding improvements is extremely important, but this task is sometimes overlooked, especially for home improvements. Generally, you need to keep the records of all improvements for 3 years (and perhaps longer, depending on your state’s rules) after you have filed the return on which you report the disposition of the asset.
Gift Basis – If you receive a gift, you assume the donor’s (giver’s) adjusted basis for that asset; in effect, the donor transfers any taxable gain from the sale of the asset to you.
Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. However, your mother originally purchased the shares for $5,000. You assume your mother’s basis of $5,000; if you then immediately sell the shares, your taxable gain is $15,000 – $5,000 = $10,000.
There is one significant catch: If the fair market value (FMV) of the gift is less than the donor’s adjusted basis and you then sell it for a loss, your basis for determining the loss is the gift’s FMV on the date of the gift.
Example: Again, say that your mother purchased stock shares for $5,000. However, this time, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. In this case, your tax-deductible loss is only $1,000 (the sales price of $3,000 minus the $4,000 FMV on the date of the gift), not $2,000 ($3,000 minus your mother’s $5,000 basis).
Inherited Basis – Generally, a beneficiary who inherits an asset uses the asset’s FMV on the date of the owner’s death as the tax basis. This is because the tax on the decedent’s estate is based on the FMV of the decedent’s assets at the time of death. Normally, inherited assets receive a step up (increase) in basis. However, if an asset’s FMV is less than the decedent’s basis, then the beneficiary’s basis is stepped down (reduced). (Congress has been considering a change that would make the inherited basis the amount of the decedent’s adjusted basis, thus eliminating the beneficial step-up in basis rule. Please check with this office for the current status of the legislation.)
Example: You inherited your uncle’s home after he died in 2020. Your uncle’s adjusted basis in the home, which he purchased in 1995, was $50,000, and its FMV was $400,000 when he died. Your basis in the home is equal to its FMV: $400,000.
Example: You inherit your uncle’s car after he died in 2020. Your uncle’s adjusted basis in the car, which he purchased in 2015, was $50,000, and its FMV was $20,000 at his date of death. Your basis in the car is equal to its FMV: $20,000.
An inherited asset’s FMV is very important because it is used to determine the gain or loss after the sale of that asset. If an estate’s executor is unable to provide FMV information, the beneficiary should obtain the necessary appraisals. Generally, if you sell an inherited item in an arm’s-length transaction within a short time, the sales price can be used as the FMV. A simple example of a transaction not at arm’s length is the sale of a home from parents to children. The parents might wish to sell the property to their children at a price below market value, but such a transaction might later be classified by a court as a gift rather than a bona fide sale, which could have tax and other legal consequences.
For vehicles, online valuation tools such as the Kelly Blue Book can be used to determine FMV. The value of publicly traded stocks can similarly be determined using website tools. On the other hand, for real estate and businesses, valuations generally require the use of certified appraisal services.
The foregoing is only a general overview of how basis applies to taxes. If you have any questions, please call this office for help.
