What is Tax Basis? For tax purposes, the term "basis" describes the monetary value utilized to determine a gain or loss. For example, if you buy 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 determined based on the difference between the sales price and the basis: $3,000-- $1,000 = $2,000. This is a simplified example, obviously-- under real circumstances, purchase and sale expenses are added to the basis of the stock-- but it offers an intro to the principle of tax basis.
The basis of a possession is really important because it is used to determine deductions for depreciation, casualties and depletion, as well as gains or losses on the disposition of that possession.
The basis is not always equal to the initial purchase price. It is established in various ways for purchases, gifts and inheritances. Additionally, the basis is not a fixed value, as it can increase after enhancements or decrease due to credits claimed, business depreciation or casualty losses. This post looks into how the basis is established in several scenarios.
The cost basis (or unadjusted basis) is the amount initially paid for an item prior to any enhancements and prior to any credits, business depreciation, expensing or adjustments due to a casualty loss.
Adjusted Basis-- The adjusted basis begins with the initial cost basis (or gift or inherited basis), then integrates the following modifications:
Let's say you bought a house for $250,000, which is the cost basis. You added a room for $50,000 and a solar power system for $25,000, then changed the old windows with energy-efficient double-paned windows at a price of $36,000. You claimed tax credits of $7,500 and $200, respectively, for the solar system and windows. The adjusted basis is therefore $250,000 + $50,000 + $25,000 - $7,500 + $36,000 - $200 = $353,300. Your payments for repairs and repainting, however, are upkeep costs; they are not tax deductible and do not contribute to the basis.
As the owner of a welding business, you bought a portable trailer-mounted welder and generator for $6,000. After using it for 3 years, you then decide to sell it and purchase a bigger one. Throughout this period, you used it in your business and deducted $3,376 in related deprecation on your income tax return. Therefore, the adjusted basis of the welder is $6,000-- $3,376 = $2,624.
Keeping records regarding enhancements is incredibly important, however this task is often neglected, especially for house enhancements. Usually, you want to keep the records of all enhancements for 3 years (and maybe longer, depending on your state's rules) after you have filed the return on which you report the disposition of the possession.
If you are given a gift, you presume the donor's (giver's) adjusted basis for that asset; in reality, the donor transfers any taxable gain from the sale of the possession to you.
Your mom gives you stock shares that have a market value of $15,000 at the moment of the gift. However, your mom initially bought the shares for $5,000. You presume your mom'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 major catch: If the fair market value (FMV) of the gift is lower than the donor's adjusted basis and you then sell it for a loss, your basis for establishing the loss is the gift's FMV on the date of the gift.
Once again, suppose that your mom bought stock shares for $5,000. But, now, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. 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 mom's $5,000 basis).
Usually, an heir 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. Usually, inherited possessions get a step up (increase) in basis. However, if an asset's FMV is less than the decedent's basis, then the recipient's basis is stepped down (lowered). (Congress has been thinking about a change that would make the inherited basis the amount of the decedent's adjusted basis, therefore removing the favorable step-up in basis policy. Please contact MY CPA PRO for the current status of the legislation.).
Example: You inherited your uncle's house after he passed away in 2020. Your uncle's adjusted basis in the house, which he bought in 1995, was $50,000, and its FMV was $400,000 when he passed away. Your basis in the house amounts to its FMV: $400,000.
You inherit your uncle's truck after he passed away in 2020. Your uncle's adjusted basis in the truck, which he bought in 2015, was $50,000, and its FMV was $20,000 at his date of death. Your basis in the truck amounts to its FMV: $20,000.
An inherited asset's FMV is extremely important since it's used to establish the gain or loss after the sale. If an estate's executor is not able to give FMV info, the recipient needs to acquire the needed appraisals. Usually, if you sell an inherited item in an arm's- length deal within a short time, the sales price could be used as the FMV. A quick example of a transaction not at arm's length is the sale of a house from parents to children. The parents could wish to sell the house to their children at a price below market price, but such a deal could eventually be classified by a court as a gift instead of an authentic sale, which might have tax and other legal consequences.
For cars, online valuation tools like the Kelly Blue Book could be used to establish FMV. The value of publicly traded stocks can likewise be established using online tools. However, for real estate and businesses, valuations usually require using qualified appraisal services.
The foregoing is just a basic introduction of how basis applies to taxes. If you have any concerns, please contact MY CPA PRO