What is Tax Basis and Why Is It So Important?
For tax purposes, the term “basis” refers to the monetary value used to measure a gain or a 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 sale 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.
The basis of an asset is a very important concept for tax purposes because it is used to calculate deductions for depreciation and casualties, as well as gains or losses on the disposition of that asset.
It is important to keep in mind that 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. Below is a primer on how 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, as well as 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) and then incorporates the following adjustments:
- Increases for any improvements (capitalizing the asset instead of expensing)
- Reductions for tax credits claimed based on the original cost or the cost of improvements
- Reductions for any claimed business depreciation or expensing deductions
- Reductions for any claimed personal or business casualty-loss deductions
Example: You originally purchased a home for $250,000. You added a room for $50,000, installed an electric solar system for $25,000, and replaced the old windows with energy-efficient, double-paned windows at a cost of $36,000. You claimed tax credits of $7,700 for the solar system and the windows, leaving you with an adjusted basis of $353,300 for your home. ($250,000 + $50,000 + $25,000 + $36,000 = $361,000 – $7,700 = $353,300)
Example: As the owner of a welding company, you purchased a generator for $6,000. After owning it for three years, you sell it to another welder. This was business property and you had taken depreciation of $3,376 over the three years. Your adjusted basis of the generator prior to the sale was $2,624. ($6,000 – $3,376 = $2,624)
Gift Basis – If you receive a gift, you assume the donor’s adjusted basis for that asset. In effect, the donor transfers any taxable gain from the sale of the asset to you (but not necessarily the loss).
Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. She 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 $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: Let’s again assume 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 sale price of $3,000 minus the $4,000 FMV on the date of the gift.)
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. The tax on the decedent’s estate is based on the FMV of the decedent’s assets at the date of death.
Example: You inherit your uncle’s home after he died in 2020. Your uncle’s adjusted basis on the home which he purchased in 1995 was $50,000, and its FMV was $400,000 when he died. Your basis on the home is equal to its FMV or $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 or $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. 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.
For most other assets, like real estate or family businesses, valuations generally require the use of certified appraisal services. The valuation team at Cray Kaiser is well versed in assisting clients with these more complex assets. If you have questions about your tax basis or business valuation and want to discuss how it might affect your tax situation, please contact RBI member CRAY KAISER.