Tax Basis: What Is It? Why Is It Important?
Tax Basis: What Is It? Why Is It Important?
Updated November 25, 2008
Carol A. Pettit
Legislative Attorney
American Law Division
Tax Basis: What Is It? Why Is It Important?
Summary
“Tax basis” is one factor used to determine the income tax consequences when
an item is disposed of, whether by sale, abandonment, or contribution. The initial
basis is usually cost; however, the basis of a gift is related to its basis in the donor’s
hands, and the basis of inherited property is generally the property’s fair market value
on the date of death. The taxpayer’s use of the item and subsequent events may
require adjusting the original basis, which leads to the term “adjusted basis.”
Adjustments may either increase or decrease the taxpayer’s basis in the property.
On July 30, 2008, Congress passed the Housing Assistance Tax Act of 2008 as
part of the Housing and Economic Recovery Act of 2008 (P.L. 110-289). It includes
a refundable credit for first-time homebuyers. Unlike other proposals for homebuyerth
tax credits considered by the 110 Congress (H.R. 5565; S. 12, S. 2566, S. 2734),
taxpayers generally are not required to reduce their basis in their newly acquired
property by the amount of the credit, but are required to pay the credit back. There
is a provision for reducing the basis by the credit if the taxpayer sells the property
before repaying the credit. In this case, the reduced basis is used to determine
whether the taxpayer must repay the remaining credit.
Other recently passed legislation requires reduction in the basis of a taxpayer’s
principal residence if the taxpayer has cancelled mortgage debt that is excluded from
gross income (P.L. 110-142). The Internal Revenue Code (I.R.C.) has a number of
provisions that require taxpayers to reduce their basis in property and others that
allow them to increase their basis in property.
Contents
Purpose and Scope.............................................1
What Is “Tax Basis”?...........................................1
How Is the Initial Basis Calculated?...............................1
Purchased Property — I.R.C. § 1012...........................1
Inherited Property — I.R.C. § 1014............................1
Gifts — I.R.C. § 1015......................................2
How Is Basis Adjusted?.........................................3
Decreases in Basis.........................................3
Increases in Basis..........................................5
How Is Basis Used in Tax Law?..................................5
Depreciation of Business-use Property — I.R.C. § 167............5
Determining Gain or Loss when Property Is Sold — I.R.C. § 1001...6
Tax Basis: What Is It? Why Is It Important?
Purpose and Scope
This report provides a simplified explanation of the meaning of “tax basis,” the
factors that determine a taxpayer’s tax basis, and some of the ways in which tax basis
is used. It is intended to address some situations encountered by individual taxpayers
and small businesses. It does not address tax basis as it applies to corporate assets
nor as it applies to shareholders’ basis in stock received in exchange for property
contributed to a corporation. The tax basis and sale of inventory is also outside of
the scope of this report, as is the basis of property that is converted from personal use
to business use.
The basis rules are found in the Internal Revenue Code (I.R.C.) §§ 1011 - 1023.1
This report is only a general overview of a very complex topic.
What Is “Tax Basis”?
Tax basis is the amount that a taxpayer can use as the cost of property that is
sold, abandoned, or given away. When property is sold, taxpayers must report gain
if the amount received for the property is more than the property’s tax basis. Gain
must be reported even if the property was only used for personal purposes. When the
tax basis is more than the property’s sales price, the result is a loss. However, the
loss generally cannot be used on a tax return if the property was only used for
personal purposes. When property is abandoned, a taxpayer who used the property
to produce income may be able to deduct the basis of the property on the tax return
for the year in which the property is abandoned. When property is given as a gift to
another person, the donor’s basis is important because it affects the recipient’s basis
in the property.
How Is the Initial Basis Calculated?
There are basically three ways of acquiring property: purchase, inheritance, and
gift. The basis of property depends on how it was acquired.
Purchased Property — I.R.C. § 1012. The initial basis of property that is
purchased is the purchase price, including sales tax. If a rebate is received, the basis
must be reduced by the amount of the rebate.
Inherited Property — I.R.C. § 1014. The initial basis of property that is
inherited is what it was worth on the day that the person from whom it is inherited
1 The Internal Revenue Code is Title 26 of the United States Code.
died. There is an exception if the estate chose the “alternative valuation date” for
valuing the entire estate. In that case, the initial basis of the property would be its
valuation six months after the date of death. Whichever date is chosen by the estate
for valuation, generally the property is valued at its fair market value on that date.
There are some special rules for family farm property, and the value of minority
shares of stock in closely-held corporations may be reduced. However, the general
rule is that when property is inherited, the recipient’s basis in the inherited property
is the fair market value of the property on the date of death. This “step-up” in basis
would be eliminated for one year in 2010, but under current law, would be in effect
for years after 2010. However, a number of laws were introduced in the 110th
Congress that would have changed this. More information about these proposals can
be found in CRS Report RL34374, Estate Tax Legislation in the 110th Congress, by
Nonna A. Noto.
Gifts — I.R.C. § 1015. Property that is received as a gift is the most difficult
category for determining initial basis. If the gift’s value required gift tax to be paid,
that tax may increase the recipient’s basis in the gift. Several factors determine the
extent to which the basis would be increased; therefore, this report will not address
the effect of gift tax on the recipient’s basis in the property.
Even if there is no gift tax involved, determining the recipient’s basis of gifts
can be complex. The basis may be the same as the donor’s adjusted basis —
discussed below. This is always the case when the fair market value (FMV) of the
gift, at the time it is given, is greater than the donor’s basis in the gift. However, in
many cases, the FMV is lower than the donor’s basis. This must be considered in
determining whether there is a gain or loss when the recipient sells the property.
If the FMV of the gift was lower than the donor’s adjusted basis at the time of
the gift, the donor’s adjusted basis is the starting point for determining how much
gain is realized when the property is sold by the recipient. However, if the sales price
is lower than the donor’s adjusted basis, the FMV at the time the gift was received
will be the recipient’s initial basis in the property for determining the amount of loss
from the sale. In some cases, there will be no gain and no loss, as discussed later.
Basis Determination Example — FMV Is Greater than the Donor’s Basis.
“Mom” gives “Daughter” a ring that Mom bought 10 years ago for $500; there are
no adjustments to the basis, so Mom’s basis in the ring was $500. The ring’s current
FMV is $1,200. Daughter’s basis in the ring is $500.
Basis Determination Example — FMV Is Less than the Donor’s Basis.
“Mom” gives “Son” a desk when he goes away to college. Mom paid $400 for the
desk when she bought it at a resale shop in 2000, has only used it for personal
purposes, and has no adjustments to her basis in the desk. Her basis is, therefore,
$400. The FMV of the desk is only $300 when Son receives it. If Son later sells the
desk, his basis will depend on the sales price of the desk.
!Sale Price Less than Donor’s Basis — If Son sells the desk for $250,
his basis for determining loss would be $300 — the FMV when
Mom gave him the desk.
!Sale Price More than Donor’s Basis — If Son sells the desk for
$425, his basis for determining gain would be $400 — Mom’s basis
in the desk.
How Is Basis Adjusted?
A taxpayer’s basis in property may be increased or decreased after the property
is acquired. The most common situation in which the basis in property is decreased
is when the taxpayer uses the property for work or business and is allowed to take a
deduction for tax purposes. The most common situation in which the basis in
property is increased is when the owner improves the property and incurs expenses
in making the improvements.
Decreases in Basis. Although decreases in basis are most common for
property used for work or business, decreases may also occur in property that is only
used for personal purposes.
Business-use Property. Tax deductions are often available for property that
is used for work or business.2 The basis of business-use property must be reduced
by the deductions that are allowed for the property. Property that is expected to last
more than a year generally must be depreciated over its useful life. This would mean
that each year a portion of its cost could be deducted on the taxpayer’s return. In
contrast, the entire cost of property expected to last for no more than one year would
be deducted in the year it was first used. Thus, this property’s basis would be zero
at the end of the first tax year.
Property with a useful life of more one year includes equipment, automobiles,
and buildings, including rental property. For this property, the original basis of
business-use property is reduced each year by the depreciation that is allowable on
the tax return whether or not that depreciation was actually claimed on the tax return.
If the taxpayer claimed more depreciation than was allowable, the larger amount is
used to reduce basis. This means that if depreciation could have been taken, it will
reduce the basis of the property even if that depreciation was never claimed on a tax
return. This concept is particularly important for people who own residential
property that they rent out. Even if taxpayers do not take the depreciation deduction,
they will still have to reduce their basis in the property when calculating their gain
on the sale of the property.
Personal-use Property. A taxpayer may need to reduce the basis in either
business- or personal-use property if that property is damaged (a casualty loss) and
the taxpayer receives an insurance settlement or other payment for the damage. If a
car is damaged by hail and the owner receives a check from the insurance company
for the damage, the basis in the car must be reduced by the amount of the check. If
the car is later repaired, the basis will be increased as explained later.
In some cases, the basis in personal-use property may need to be reduced
because the buyer was able to reduce her tax liability as a result of the purchase. The
2 See 26 U.S.C. §§ 162, 167, 179.
most common example of this involves the purchase of a principal residence.
Current law allows the buyer to take a deduction on Form 1040 Schedule A for the
points3 that were paid by the seller. The basis of the residence then must be reduced
by the amount of the points.4 Tax credits for those who purchase certain financially
distressed properties as their principal residence were proposed in the 110th
Congress.5 Each of the proposals would require buyers to reduce their basis in the
residence by the amount of the credit.
The Mortgage Forgiveness Debt Relief Act of 2007 (P.L. 110-142) allows
taxpayers to exclude debt cancellation from income when part of the acquisition debt
on their principal residence is cancelled or forgiven. However, taxpayers taking
advantage of this provision must reduce their basis in their principal residence by the
amount of the debt cancellation income that was excluded from income.6
The Housing Assistance Tax Act of 2008 (P.L. 110-289) provides a refundable
tax credit to first-time homebuyers who purchase a principal residence after April 8,
2008, and before July 1, 2009. The credit is generally repaid over a 15-year period
and the basis of the property is not reduced by the credit. However, if the property
is sold before the credit is fully repaid, the taxpayer generally must repay the
remaining amount in the year of the sale. An exception exists if the gain on the sale
is less than the outstanding credit. To determine whether any or all of the
outstanding credit must be repaid, the gain must be recalculated. For this
recalculation, the adjusted basis of the property must be reduced by the outstanding
credit. This reduction in basis is used only to determine repayment of the credit. It
is not used to determine the gain realized for tax purposes.7
A less common situation in which basis in personal-use property would be
reduced involves an easement. In this situation, the property owner grants someone
else the perpetual right to non-exclusive use of part of the property.8 An example
would be allowing an adjacent property owner to use a driveway on the first owner’s
land. If payment was received in exchange for this perpetual right, the amount
received for the use of the driveway would reduce the basis of the land where the
driveway was located. Another situation would involve a severance award connected
with an “involuntary conversion” or “condemnation.” An example would be a house
3 These are generally a loan origination fee and discount points, which are both reported on
the closing statement.
4 This only applies to points paid by the seller. Points paid by the buyer do not reduce basis.
See Rev. Proc. 94-27, 1994-1 C.B. 613 (Mar. 28, 1994).
5 H.R. 5565; S. 12, S. 2566, S. 2734.
6 For more information about the Mortgage Forgiveness Debt Relief Act of 2007, please see
CRS Report RL34212, Analysis of the Proposed Tax Exclusion for Canceled Mortgage Debt
Income, by Mark P. Keightley and Erika Lunder.
7 For more information about the first-time homebuyer credit, please see CRS Report
RL34664, The First-Time Homebuyer Tax Credit, by Carol A. Pettit.
8 If the right was for a fixed period of time, rather than perpetual, money exchanged for the
temporary easement would generally be considered rent and, therefore, includible in gross
income when received. Rents received do not reduce the basis of the underlying property.
owned on a narrow street that the city has decided to widen. Part of the land the
house is on will be used for the wider street. The land owner might be given a
severance award to compensate for expenses that would be incurred to replace a
fence, trees, etc. The severance award would reduce the basis on the remaining
property; however, that basis would be increased to the extent that money was spent
to install a new fence, etc.
Increases in Basis. The most common way in which basis in property is
increased is by improvements made to the property. Improvements must be
distinguished from repairs. Repairs are generally maintenance expenses. These
would include painting a house, repairing a roof, sealing a driveway, cleaning
airducts, changing oil in a car, and having a ring cleaned and prongs tightened. In
contrast, improvements would include adding a room to your house, replacing the
entire roof on a building, paving a driveway, putting a new engine in a car, and
replacing a small stone in a ring with a larger one. Improvements also include
restoring damaged property to the condition it was in before the casualty loss.
In the case of a casualty loss, such as the car with hail damage that was
discussed above, basis would have been reduced by the insurance settlement, but
restoring the car to its previous condition would increase the basis by the amount
spent on restoration. As an example, consider a car whose adjusted basis was
$11,000 before the hail damage. The insurance company determined that there was
$1,500 in damage to the car. The owner’s policy had a $500 deductible; therefore,
the check from the insurance was only $1,000. The adjusted basis in the car is
$10,000 ($11,000 - $1,000) after the owner receives the insurance check. By
shopping around, the owner finds someone who will restore the car for $1,200. The
basis in the car after the owner pays $1,200 for the restoration is $11,200 ($10,000
+ $1,200). It does not matter that the restoration was done for less than the insurance
company estimated. Similarly, if the owner found that all the reputable repair
facilities cost more than the $1,500 estimated by the insurance company, the basis
would be increased by the amount paid for the restoration. If the restoration cost
$1,800, the owner’s basis in the car would be $11,800 after restoring it. Furthermore,
the cost of restoring damaged property increases the property’s basis even if there had
been no decrease in the basis from insurance proceeds (or other settlement).
When free labor, by the owner or by friends and family, is used to improve
property, there is no increase in basis for the value of the work performed —
sometimes called “sweat equity.” The value of the property may increase, but the
basis is unchanged unless there are out-of-pocket expenses incurred for the
improvements.
How Is Basis Used in Tax Law?
Basis determines whether there is a gain or loss when property is sold. For
business-use property, basis is one factor used to determine allowable depreciation.
Depreciation of Business-use Property — I.R.C. § 167. Depreciation
for business-use property is based on the property’s basis and its “class-life.” If
improvements are made to the property, those improvements are depreciated
separately from the original property, but the adjusted basis of the improvements
increases the adjusted basis in the property when it is sold.
Determining Gain or Loss when Property Is Sold — I.R.C. § 1001.
When property is sold, the gain or loss is determined by subtracting the adjusted basis
of the property from the sales price. If the difference is greater than zero, there is a
taxable gain. If less than zero, there is a loss, but its deductibility for tax purposes
will depend upon whether the property was used for business, investment, or personal
purposes.
Gains. The taxable gain generally is the difference between the sales price and
the adjusted basis, but the gain can be reduced by expenses incurred in selling the
property. This is true whether the property was business-use property or only used
for personal purposes.
Gain Calculation Example. A man received a stuffed animal costing $2 as
a gift from his parents thirty years ago. This man has now discovered that this
particular toy is considered rare and valuable and decides to sell it on an Internet
auction site. The man’s adjusted basis in the toy is $2 — his parents’ basis when
they gave it to him. The sales price is $150. The difference is $148, but he had to
pay $15 to the auction site and $5 to ship the toy to the buyer. His gain on the sale
is $128 ($150 -$2 - $15 - $5 = $128).
Losses. Calculating losses is done in a similar way; however, only losses
generated by business- or investment-use property can reduce taxable income.
Losses on personal-use property cannot be deducted. Sales expenses increase the
amount of loss.
Loss Calculation Example — Business-use Property. A landscaper owns
a large mower that was purchased for $2,500 in July 2005. The allowed and
allowable depreciation is $1,775 for the period of ownership and use. Thus, the
adjusted basis is $775 ($2,500 - $1,775 = $775). An advertisement costing $50 was
placed in the local paper to sell the mower. The mower was sold for $500. The
landscaper’s tax return will report a $325 loss from the sale of the mower ($500 -
$775 = -$275; -$275 - $50 = -$325).
Loss Calculation Example — Personal-use Property. A couple received
a china gravy boat as a wedding present. The gift cost $150. They received no other
china in the pattern they had chosen and have realized they will not be using the
gravy boat. So they list the gravy boat on an Internet auction site. When the bidding
closes, the winning bid is only $100. The fee for the auction site is $10 and it cost
another $15 to ship the gravy boat to the buyer. There is a $75 loss on the sale ($100
- $150 = -$50; -$50 - ($10 + $15) = -$75). Since the gravy boat was personal-use
property, the loss cannot be claimed on the couple’s tax return; however, the $100
received is not included in gross income. (This is why money generated by a
personal garage sale is generally not includible in income for tax purposes.)
No Gain, No Loss. Gifts, as noted earlier, are complex. In some cases,
property received as a gift may be sold with no resulting gain or loss. This occurs
when the sale price is more than the property’s FMV at the time of the gift, but less
than the donor’s basis.
Example of No Gain, No Loss Sale — Sale Price Less than Donor’s
Basis, but More than FMV at the Time of the Gift. Refer to the earlier example
where Son received a desk from Mom. The donor’s basis was $400, but FMV at the
time of the gift was $300. If Son sells the desk for $325, he will have no gain and no
loss:
!Donor’s basis is used to calculate gain — $325 - $400 = -$75, so
there is no gain;
!FMV at the time of the gift is used to calculate loss — $325 - $300
= $25, so there is no loss.