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Accounting Terms: Why Tax Basis Is So Important?

by
Julie Farless
on
4/28/2019
Accounting Terms: Why Tax Basis Is So Important?

One of the most important accounting terms needed for calculating tax issues is “basis.” Basis is the primary tool used to determine the amount of gain or loss on an asset, and though the most rudimentary definition of basis is the price originally paid, there can be tremendous variation on the actual application of the term depending upon specific circumstances. Variables such as depreciation and casualty loss, improvements, depletion and purchase and sale costs all come into play in helping to determine deductions that can be taken, and taxes owed. The way that basis is defined is also dependent upon the purpose for which it is needed: purchases are treated differently than are gifts or an inheritance. Let’s take a look at the various types and definitions of basis, and the correct approach for each of these different situations.

Cost Basis

Cost basis is the most simple and straightforward definition of basis. It is the dollar amount that was paid for its acquisition, with no additions, subtractions or adjustments for improvements, depreciation, expensing, or casualty losses.

Adjusted Basis

When you add or subtract from the original cost basis the costs of improvements or reductions for expensing deductions, claimed business depreciation, or claimed personal or business casualty losses, the number you end up with is the adjusted basis. In cases involving gifts or inheritance, the original cost basis is not necessarily the price that was originally paid, and the costs of repairs or maintenance do not count as improvements.

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. The adjusted basis is thus $250,000 + $50,000 + $25,000 + $36,000 = $361,000. 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.

Tax laws generally require that records of improvements be kept for a minimum of three years after the date that you file a return on which you assert an adjusted cost basis for a disposed asset, and some states require that they be kept longer. Having this documentation to support your adjusted cost basis is important, especially for home improvements. 

Gift Basis

Calculating the adjusted cost basis for an asset received as a gift is treated somewhat differently, as it must take into account the doner’s original cost basis as well as the value on the date that the gift was bestowed. Calculating this accurately is important, as the recipient of a gift assumes financial responsibility for any taxable gains on the item, as seen in the example below.

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.

The exception to this is where the original owner’s adjusted basis is higher than the fair market value (FMV) of the asset at the time that the gift is given, and the asset is sold at a loss, then your adjusted basis is calculated based on the asset’s fair market value when it was given to you, as in the example below.

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

Calculating an inheritance basis is also done differently. Tax on the estate of a person who has died is calculated based on the Fair Market Value of their assets when they die, and that same Fair Market Value is generally the same one that the beneficiary of the asset is to use as their inherited basis. Though most inherited assets’ increase in value, there are some situations where the basis reflects a depreciation. This is seen in the two examples shown below. 

Example: You inherit your uncle’s home after he dies. Your uncle’sadjusted basis in the home was $50,000, but he purchased the home 25 years ago, and its FMV is now $400,000. Your basis in the home is equal to its FMV: $400,000.

Example: You inherit your uncle’s car after he dies. Your uncle’sadjusted basis in the car was $50,000, but he purchased the car 5 years ago, and its FMV is now $20,000. Your basis in the car is equal to its FMV: $20,000.

Though at the time a beneficiary inherits an asset the inheritance basis may not seem important, the information is critical should they decide to sell what they’ve inherited. At that point they will need to determine what their gain or loss has been on the item, so getting the Fair Market Value from the estate’s executor is important. Should that information be unavailable, having the asset appraised by a certified appraiser at the time it is inherited would be a wise move, though there are specific ways to determine Fair Market Value for different types of items, such as the Kelly Blue Book for vehicles and a variety of online tools for publicly traded stocks.

Should you decide to sell an inherited item within a short time of inheriting it, you are able to use the price that you sell it for as the Fair Market Value as long as the sale is what is known as an “arms-length transaction.” This is different from a transaction that might, for example, be made between parents and their child at below market value. The court wants to know that the price paid for an item was derived from a bona fide sale.

There is more to know about basis and how it affects taxpayers in different situations. For more detailed information, speak to a qualified tax professional.

Martinez & Shanken, PLLC writes for TaxBuzz, a tax and accounting news and advice website. Reach the firm at [email protected]

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Julie Farless

Julie Farless

Martinez & Shanken, PLLC is a Certified Public Accountant (CPA) firm based in Gilbert, Arizona. We provide a full range of accounting, bookkeeping, consulting, outsourcing and business services, but we specialize in tax preparation. We work with you to ensure that your personal or business processes are conducted in a manner that ensures ongoing integrity in your financial transactions. We are available to answer your questions and help with your ongoing tax planning and changing business needs.

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