The tax basis of an asset for Income Tax purposes (“Basis”) is the figure used to determine how much can be depreciated and whether a taxpayer has a gain or loss when they sell that asset. Whether you know it or not, everyone has a Basis in every asset that they own.
For non-business assets, taxpayers may not care about their Basis until a taxable event takes place. The event could be the sale, gift (whether lifetime or as a result of their death) or conversion of the asset to business use.
For business assets, taxpayers must know what their Basis is in order to determine income tax depreciation and for the sale of the asset.
Basis Starting Points:
The following are the starting points for determining Basis:
Purchase: Your Basis in an asset that you purchase is generally the price that you paid. However, there are some adjustments that can be made (up or down). Here are some common adjustments:
Certain costs associated with the purchase of an asset are “capitalized” into the Basis. That is, they increase the Basis. Examples of capitalized costs include:
- Sales tax that is not deducted.
- Certain legal, accounting and other costs associated with the purchase of real estate, equipment, a business, etc.
- Freight costs.
- For manufacturers, the Uniform Capitalization Rules must be followed to determine which direct and indirect costs must be capitalized into inventory rather than deducted as a current expense.
- Certain costs of research and development must be capitalized into intangibles such as patents, copyrights, trademarks and other intellectual property rights.
- Purchase of Business.
- Stock Purchase: When a taxpayer purchases the stock of a corporation or membership interest in an LLC the taxpayers Basis in the stock or membership interest is what they paid for it. The Basis of the underlying assets of the business are not affected. There is an exception for entities taxed as partnerships for which an IRC Section 754 Election is made.
- Asset Purchase: When a taxpayer purchases a business by purchasing the assets they must allocate the purchase price (together with capitalized costs associated with the purchase) among the assets purchased. The Federal Income Tax laws require that the buyer and seller agree as to how the purchase price is to be allocated and report this the same way. While the Federal Tax laws require that the allocation be reasonable in relation to true values, this is often a vigorously negotiated term of the purchase contract.
For example, let’s say that ABC Printing, Inc. sells all of its assets to XYZ Graphics, Inc. for $10 million. ABC and XYZ agree to allocate the $10 million purchase price as being $1 million for the printing press and $9 million for the building. ABC must report the sale of the printing press for $1 million and the sale of the building for $9 million. XYZ must use $1 million as the Basis for the printing press and $9 million for the building.
Since the depreciable life of a building is much longer than that of a printing press, XYZ will get lower depreciation deductions in the early years after purchase than they would have gotten had the allocation been reversed. If XYZ holds both assets long enough they will end up with the same total amount of depreciation deductions. However, due to the time value of money, taxpayers would rather have a $100 deduction today than a $100 deduction 30 years from today.
- Bartering Services: If a taxpayer acquires an asset by trading their services the Federal Income Tax laws require that the taxpayer recognize income equal to the FMV of their services. The Basis of the new asset is equal to the income recognized by the taxpayer.
- Sweat Equity: If a taxpayer uses their own labor to create an asset they get no Basis for their sweat equity. For example, if a taxpayer buys building materials and puts an addition on their home or office, they get to capitalize the cost of the building materials and add that to Basis. However, they do not get to capitalize the “value” of their labor.
At the same time, if they elect to pay themselves for their labor, they get to capitalize and add to basis the amount that they paid themselves. Of course, the trade-off is that the taxpayer will have to recognize income equal to the payment. This is generally not advisable since the taxpayer will have to recognize income currently, but perhaps not get the tax benefit of a higher
Basis for many years to come, or possibly never get the tax benefit.
Taxpayers often trade-in an old piece of equipment when they purchase new piece of equipment. In this case, the taxpayers Basis in the new equipment is equal to the Adjusted Basis of the old equipment traded plus the additional cash paid.
For example, Ralph’s Hauling Corp. wants a new dump truck that has a purchase price of $50,000. Ralph’s negotiates with the dealership and agrees to give the dealership its old dump truck plus $32,000 of cash for the new dump truck. The Adjusted Basis of Ralph’s old truck is $8,000 at the time of the trade-in. Ralph’s Basis in the new truck is $40,000 ($8,000 + $32,000 = $40,000).
Section 1031 Like-Kind Exchanges:
Taxpayers who perform Like-Kind Exchanges pursuant to IRC Section 1031 must follow special rules to determine what their Basis is for their new replacement asset.
Briefly, a Like-Kind Exchange is a technique for trading/selling certain types of properties without having to recognize gain for income tax purposes. The gain is not necessarily eliminated forever. Rather, if done properly, the gain is merely deferred until it is triggered by some future event such as a sale of the newly acquired replacement property.
The Basis in the newly acquired replacement property is determined in relation to the Basis in the old relinquished property, with some adjustments. Briefly, the Basis of the new replacement property is the same as the old relinquished property (i.e. Carry-Over Basis) as adjusted for the following:
- Increased by additional money paid or additional debt incurred to acquire the new replacement property; and
- Decreased by money received from the sale of the old relinquished property that was not reinvested into the new replacement property or where the debt on the new replacement property is lower that it was on the old relinquished property. This is often referred to as “boot”.
Your Basis in an asset that you receive as the beneficiary of a lifetime gift (i.e. the giver makes a completed gift to you while they are alive) is generally whatever the Basis was in the hands of the giver on the date that the completed gift was made. This is referred to as “Carryover Basis”.
The Basis of an asset that you inherit (i.e. you receive it as a result of someone’s death) can only be determined by knowing the year that the giver died. If they died in 2010 the rules become quite complicated. Please note that the determination is based upon when the giver died, not when you ultimately receive the asset.
Prior To 2010 and After 2010:
Under the current law, where the giver died prior to 2010 (or dies after 2010), the Basis of inherited assets (in the hands of the beneficiaries) is set at the Fair Market Value (“FMV”) of the asset on the date of the decedent’s death. If Basis of all the combined assets of an Estate (determined for Estate Tax purposes) was higher on the 6 month anniversary of the date of death, the Executor could elect to use that alternative 6 month FMV as Basis of the assets. This adjustment (whether up or down) is generally referred to as “Stepped-Up Basis”.
The theory behind the Step-Up was that if the asset was subject to Federal Estate Tax (even if no Estate Tax resulted) then taxpayers should get a benefit for Income Tax purposes. If the FMV was used to determine an Estate Tax, it would only be fair that the beneficiaries should then get the benefit of the same FMV when it came time to determine their Basis in those assets. While few taxpayers ended up paying an Estate Tax all of the beneficiaries got the benefit of the Step-Up.
This means that if a decedent paid $100 for a particular stock and it was worth $300 on their date of death, the person inheriting the stock would get a Stepped-Up Basis of $300. If the beneficiary then sells the stock for $305, there is a taxable gain (for Income Tax purposes) of only $5 ($305 – $300 = $5). Without this Step-Up, the beneficiary who sells the stock for $305 would have a $205 gain ($305 – $100 = $205).
Under the current Estate Tax laws, there is no Estate Tax assessed against those who die in 2010. Since there is no Estate Tax, the Step-Up rules are different (and more convoluted) than they were for those dying prior to 2010.
Under the current tax laws where the giver died in 2010, the Basis of inherited assets (in the hands of the beneficiaries) is generally the lesser of:
- The Basis that decedent had in the asset as of his date of death; or
- The FMV of the asset on the decedent’s date of death.
Beneficiaries are then entitled to a limited Step-Up:
- For beneficiaries other than a surviving spouse, the Basis of the assets can get a Step-Up to FMV of up to $1.3 million.
- For assets inherited by a surviving spouse, the Basis of the assets are entitled to receive a “Step-Up” to FMV of up to $3 million.
The executor of the Estate can choose how to allocate the $1.3 million Step-Up among the assets. Of course, in some situations, this could be the source of conflict among beneficiaries. Depending upon how the figures fall, some beneficiaries may get assets that have Carryover Basis and others that get Stepped-Up Basis.
Most estate planning attorneys, and other observers, assumed that the government would have passed new legislation affecting the Estate Tax before January 1, 2010.
However, January 1, 2010 came and went without legislative change. The Federal
Government is currently considering how to deal with the Estate Tax for those dying in 2010 (and future years). Many lawmakers are pushing to reinstate the Estate Tax for 2010, retroactive to January 1, 2010. Of course, any law that is retroactive is problematic and could be challenged as unconstitutional. However, it does not mean that a retroactive law could not be passed. The uncertainty makes for a very awkward period for planning and action as it relates to the estate and for the beneficiaries of estate.
Post-Acquisition Adjustments To Basis:
There are many situations where a Taxpayer must adjust their Basis. Some adjustments increase Basis and some decrease Basis. Here are two common examples:
Certain assets are eligible for depreciation under the Federal Income Tax laws. That is, an owner is allowed to deduct a portion of the Basis each year. The Basis is reduced each year by the amount depreciated until the Basis was finally reduced to zero. If the taxpayer sold the asset after depreciation, the gain or loss would be determined by reference to the Adjusted Basis at on the date of sale.
It should be noted that if a taxpayer was allowed to take depreciation deductions they may have to reduce the Basis even if they did not actually take the deductions to which they were entitled. This is often referred to as the “allowed or allowable” approach to Basis reduction.
Costs that are capitalized at the time of acquisition or creation are discussed above. However, some costs can be capitalized into Basis over a period of years.
Here are some common examples:
- If a taxpayer buys land to construct a building, the real estate taxes and interest are generally required to be capitalized into the real estate rather than deducted as a current expense. This continues until the building is placed in service. Real estate taxes and interest incurred after the building is placed in service can be deducted rather than capitalized.
- If a taxpayer makes capital improvements to their residence they are entitled to increase the Basis of their Residence. Capital improvements include major landscaping, an addition, a completely new roof, installation of a paved walk or driveway, a new kitchen or bathroom, etc.
Taxpayers often sell, gift or transfer a portion of an asset. In that event, taxpayers must allocate Basis between the portion that is retained and the portion that is transferred. The allocation is to be based upon the relative values of the portion retained and the portion transferred.
If a portion of the asset is sold, the Basis allocated to the sold portion is used to determine the gain or loss for that portion. If a portion of the asset is gifted, the Basis allocated to the gifted portion is used to determine the Basis for that portion in the hands of the beneficiary.
Basis is the basis of all gains, losses and depreciation. While most taxpayers give little thought to it, Basis presents some wonderful planning opportunities as well as traps for the unwary. Either way, it cannot be ignored.
Copyright ©, Keith B. Baker – 2010
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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