Basis

Posted on July 12, 2008 
Filed Under Federal Income Tax, Key Concepts

An important reason for using the category “key concepts” to describe the federal income tax in this web log is to illustrate important relationships among these concepts and, in the process, provide the reader with the insight needed to master our enormous, and enormously complex, Internal Revenue Code. In short, to really understand the key concepts individually, one must understand them in concert.

Despite the adjective “gross,” is a net concept and not the same as . For example, the taxable portion or gain on a transaction involving the sale or disposition of property is equal to the amount realized (or gross proceeds) less return of the cost investment in the property. The taxpayer’s investment in the property is known as basis; it starts with , that is, acquisition and installation costs and is adjusted upward for substantial capital outlays (e.g., expenditures not deductible as current expenses, namely, additions, betterments, improvements, legal fees for defending title) and downward for capital returns (depreciation or other modes of cost recovery, deductible casualty losses, insurance reimbursements, tax credits, etc.). Adjusted basis is an accounting maneuver that not only makes the federal income tax a tax on net gains but also preserves the tax attributes of the property sold so that in the case of, say, a depreciable property, the government will eventually get its fair share because basis in the hands of the buyer reflects downward adjustments for depreciation taken by the seller. In sum, transactions that increase (decrease) a property’s basis will decrease (increase) gain or increase (decrease) loss upon sale or other disposition.

Of course, if the adjusted basis exceeds the amount realized, then the taxpayer experiences a loss on sale that could be deductible as a short-term or long-term capital loss provided the asset involved is not personal in nature.

As a general rule, is equal to the taxpayer’s cost investment in the property. Basis comprises cash paid or other property exchanged and any mortgage or liability assumed in the purchase of the property in question. If several properties are purchased together, basis is allocated according to each property’s proportional share of the fair market value (FMV) of the assets acquired; in this calculus, if a property is worth 60% of the total FMV upon purchase, the basis allocated to it will be 60% of the original purchase cost. (Note: FMV represents what a willing and informed buyer would pay a willing and informed seller in a fair and open transaction, what is also known as an arm’s length transaction.) More complicated calculations are required in determining . And if a transaction involves the acquisition of property in an exchange not involving cash or notes, the buyer’s basis in the property acquired is a substituted basis, that is, the new property is assigned the cost basis of the property given up–all this being grounded on the assumption that if the exchange is made at arm’s length, then the properties exchanged must be of equal value.

In the case of property acquired from a decedent, basis is stepped up or down to fair market value at the date of decedent’s death or an alternate valuation date six months after decedent’s death. The alternate valuation date may be elected only if it will reduce the value of decedent’s estate and the federal estate tax liability. Basis for property distributed before the alternate valuation date is FMV at the date of distribution or other disposition.

The basis of property acquired by gift also deviates from the general rule; it is the lesser of fair market value or the donor’s adjusted basis at the time of gift. And in contrast to inherited property, the basis of gifted property (in the lexicon of tax law, a “gifted property” is not an exceptionally intelligent property but rather something that is given away) is adjusted for tax paid on appreciation up to the time of transfer. However, if property acquired by decedent within one year of death by gift is transferred back to donor or donor’s spouse upon donee’s death, the rule that property acquired from a decedent is stepped up to fair market value is abandoned and the transferred property is assigned a basis equal to the donee’s immediately before death. This provision in the Code denies the tax benefit of a stepped-up basis to the donor in a transaction that is in substance .

Special rules apply to what is known as “loss property.” If a donor’s adjusted basis in a gifted property is greater than its fair market value, then the donee’s basis in the property is FMV for purposes of determining loss by donee on subsequent sale or disposition. (Remember the truism that the lower a property’s basis, the lower the loss upon subsequent sale.) The general effect of this rule is to disallow as a loss to donee any decline in value of a property while in donor’s hands thereby limiting the deductible loss upon subsequent sale or disposition to the decline in the property’s value while in donee’s hands. In short, the donor cannot pass on a loss built into a donated property. Please note this rule applies only to donated property sold at a loss. If the property is sold for an amount in excess of the donor’s adjusted basis, then donee will recognize a gain on the transaction.

For those interested, additional relevant articles on the concept of basis are listed below:

Many happy returns, Roger

Comments

Leave a Reply

You must be logged in to post a comment.