Basis

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 or carryover 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

Tax Brackets

The concept of tax brackets is shorthand for the grouping of various levels of taxable income according to tax rates. In a progressive tax system such as the U.S. federal income tax, the point at which an increase in taxable income results in a marginally higher tax rate marks the beginning of a new tax bracket.

For individuals filing a federal tax return in 2007, there are six tax brackets that group together tax rates and levels of taxable income according to filing status: the 10%, 15%, 25%, 28%, 33%, and the (pdf file), 35%. Individuals married filing jointly (including surviving spouses) are in the most favorable tax brackets, those married filing separately in the least favorable. An unmarried individual (or a married person living apart from his or her spouse for the last half of the tax year) who maintains a household for a child, parent, or other qualifying relative can file as head of household and land in a more favorable tax bracket than those condemned (or unwittingly choosing) to file as single or married filing separately.

For example, the 10% tax bracket includes taxable income up to $7,825 for single and married filing separately, $11,200 for head of household, and $15,650 for married filing jointly. The 15% tax bracket ranges from $7,825.01 to $31,850 for single and married filing separately, $11,200.01 to $42,650 for head of household, and $15,650.01 to $63,700 for married filing jointly. The 25% tax bracket ranges from $31,850.01 to $64,250 for married filing separately, $31,850.01 to $77,100 for single, $42,650.01 to $110,100 for head of household, and $63,700.01 to $128,500 for married filing jointly. Click on for details on the 28%, 33%, and 35% brackets. (Please note in the example that follows, I round beginning and ending amounts in tax brackets to the nearest dollar.)

For a taxpayer with enough income to fill some but not all of a bracket, the rate applicable to that bracket is the taxpayer’s marginal tax rate. Any taxable income in excess of $349,700 ($174,850 for married filing separately) is subject to the top marginal tax rate of 35%. The effective tax rate is simply tax due divided by taxable income, and the effective rate will be lower than the top or marginal rate.

As an example, a head of household filer with 2007 taxable income of, say, $97,500 from her salary as an accountant (and no capital gains or dividends, both of which are taxed according to different schedules than ordinary income), the first $11,200 will be taxed at a rate of 10% ($1,120 in taxes for this bracket), the next $31,450 ($42,650 - $11,200) at 15% ($4,717.50 in taxes for this bracket); the next and final increment of $54,850 ($97,500 - $42,650) represents this taxpayer’s top bracket and will be taxed at a marginal tax rate of 25% ($13,712.50 in taxes for this bracket). Her tentative total tax liability is $19,550. But for filers with 2007 taxable income under $100,000, the IRS requires the use of its 2007 Tax Table and, according to this table, our head of household filer will pay taxes of $19,556 because her income is at least $97,500 but less than $97,550. The (pdf file) is graded in increments of $50, and the calculation takes the tax due for the high point in the increment, adds this to the tax due for the low point, and then divides by two, rounding to the nearest dollar. So, the tax due for our head of household filer reporting $97,500 in taxable income would be $19,562.50 (tax due for high point in increment, $97,550) plus $19,550 (tax due for low point in increment, $97,500, which also happens to be our filer’s unfortunate location in this interval) or $39,112.50. Next, we divide this subtotal by two and round to the nearest dollar and arrive at the 2007 Tax Table amount of $19,556. Her effective tax rate is 20.1% (tax due of $19,556 divided by taxable income of $97,500) and lower than her marginal tax rate of 25%.

Additional resources for those interested in tax brackets are listed below:

Many happy returns, Roger

Itemized Deductions

To paraphrase Einstein, there is nothing so complicated as the income tax, and the device of itemized deductions only adds to the complexity of the Internal Revenue Code.

The proximate cause of the category (and complexity) of itemized deductions is the two-tier concept of income in our federal tax system, namely, the “tiers” of gross income and adjusted gross income.

The first tier, gross income, is a net concept despite the adjective “gross”; that is to say, gross income is not the same as gross receipts. Instead, gross income equals gross receipts less return of capital, cost of goods sold, cost of sales, or recovery of cost. In the context of this article’s focus on the federal income tax for individuals, gross income is the recipient’s net gain from a transaction not his or her gross receipts. Also note that the scope of this article is limited to a general discussion of the concept of itemized deductions; key elements in this category will be covered in subsequent articles. (But for those seeking immediate guidance on itemized deductions, see my article .)

The second tier, adjusted gross income, is gross income less certain deductions expressly authorized by Congress. The deductions taken from gross income to arrive at the intermediate figure of adjusted gross income are commonly referred to as “above the line deductions.” Because, on the whole, above the line deductions comprise trade or business deductions (but with exceptions for alimony, contributions to health savings accounts and retirement plans, and student loan interest payments, among others), they are allowed in full and not subject to a floor. (The phrase “subject to a floor” means deductible only to the extent the expense in question exceeds some baseline figure, usually a fraction of adjusted gross income). On the other hand, many deductions from adjusted gross income (itemized or “below the line” deductions) are mainly personal in nature making them subject to a floor expressed as a percentage of adjusted gross income. Moreover, itemized deductions in the aggregate benefit the taxpayer only if they exceed the standard deduction amount (the 2007 standard deduction is $5,350 for single filing status, $10,700 for married filing jointly and surviving spouse, $5,350 for married filing separately, and $7,850 for head of household); that is, the comparison will pay off only if it tips the scales in favor of itemized deductions. Adjusted gross income (AGI) is therefore a key concept in the federal income tax because it represents the line, for the most part, between business and personal expenses. As with its above the line cousin, itemized deductions abide by the general rule that deductions are not allowed unless granted by the legislative grace of Congress. (For additional details on the role of the two tiers in the federal income tax, see my earlier Key Concepts articles on and .)

Historically, itemized deductions comprise medical and dental expenses (subject to a 7.5% of AGI floor), state and local taxes, home mortgage and investment interest expenses, charitable contributions (subject to various percentage-of-AGI limitations based on type of charity and character of gift), casualty and theft losses (subject to a 10% of AGI floor plus a $100 deductible for each casualty or theft loss), job expenses, and miscellaneous deductions (subject to a 2% of AGI floor); taxpayers list these expenses on Schedule A, the official (pdf file). High income taxpayers should also note that miscellaneous itemized deductions (except for gambling losses to the extent of gambling winnings, impairment-related work expenses, and several other expenses) are not allowed in the calculation of alternative minimum tax, and other restrictions may apply for the “regular” itemized deductions that are allowed, including the imposition of a higher 10% of AGI floor for medical and dental expenses. See my previously published articles on this topic, and .

Because of concern that itemized deductions are largely personal in nature, tend to erase the progressivity of the income tax because a deduction saves more per dollar for taxpayers in higher tax brackets (i.e., the net after-tax cost per dollar for a deductible expense for individuals in the 28% bracket is 72 cents but only 65 cents for those in the higher 35% bracket), and serve in substance as a tax expenditure, Congress in 1990 decided to enact an (but no phase out for medical and dental expenses, casualty and theft losses, investment interest expenses, and wagering losses up to wagering gains) for high income taxpayers. In 2006 and 2007, taxpayers must reduce the total of itemized deductions claimed by 2% of adjusted gross income in excess of $156,400 ($78,200 for those married filing separately). This phase out of itemized deductions according to income level cannot be more than 80% of otherwise allowable deductions and it applies after subtracting various floors.

Additional resources on the key concept of itemized deductions are listed below:

Many happy returns, Roger

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