How Basis Adjustment Works
Cost basis (or tax basis) is a foundational concept in taxation. The reason behind this is very simple. Basis affects a taxpayer’s gain and therefore affects a person’s overall tax burden. The main purpose of cost basis is fairly easy to understand. Cost basis is basically a reflection of a person’s investment in a given asset. This is why cost basis affects gain. Cost basis offsets gain because it represents what a person has already invested in an asset. When you sell an asset, the sales price only reflects the current value of that asset. But a person’s gain is usually not just the current value of an asset. Gain is what a person recognizes beyond what has been invested in an asset over time.
In this post, we will discuss how cost basis can fluctuate by providing specific basis adjustment examples.
Though the essentials of cost basis are straightforward, the concept can be tricky in its entirety. Cost basis can change over time. The way in which cost basis changes depends on how the treatment of the asset. Having an understanding of cost basis is crucial for managing one’s overall tax burden. Whenever basis changes, one’s tax burden will change too. Let’s take a look at this concept in more detail.
Cost Basis is Initially the Purchase Price of an Asset
As we discuss, cost basis is a reflection of a person’s investment in a given asset. Given this fact, it should not be surprising that cost basis originates as the purchase price. This is true at least in cases of standard sales transactions. Cost basis can originate as something else in different scenarios. For instance, if a person inherits an asset following a death, the basis in the asset will be the fair market value. If a person buys a house for $1 million, then the cost basis will be the purchase price (of $1 million).
But let’s suppose someone inherits a house following the death of a relative. And let’s suppose that the person who passed away had a basis of $1.5 million. The person who inherits the property will have a basis equal to the current fair market value. This is true regardless of whatever discrepancy many exist between the original basis and the market value. In this case, let’s suppose the current fair market value is $2 million, reflecting an appreciation of $500,000. The new basis will be $2 million.
In cases such as these, this new basis is commonly referred to as a “stepped up basis,” because of the appreciation. If the person inheriting the property were to immediately sell the property for $2 million, there would be zero gain.
Another noteworthy scenario is assets received as gifts. This is another scenario in which the cost basis will not be the original purchase price. When a person receives an asset as a gift, the recipient’s basis will be the adjusted basis of the giver. This is referred to as a “carryover basis”. The adjusted basis of the giver transfers over directly to the recipient, irrespective of the original purchase price.
Depreciation (or Amortization) Will Reduce Tax Basis
One of the most common reasons for basis fluctuation is depreciation. Depreciation is another key concept in taxation. For certain assets, owners can take deductions to compensate for the decline in the asset’s value. The depreciation schedule will vary depending on the type of asset, accounting method, and so forth. The owner takes a deduction to lower his or her tax liability for the year, and decreases the basis in the asset accordingly. This makes intuitive sense, because depreciable assets will typically have less value on the market over time. The decrease in basis mirrors the declining market value. Depreciation will therefore affect how much gain to ultimately recognize when selling an asset. What’s more, depreciation deductions may also be taxed separately from gain through “depreciation recapture.” Depreciation recapture taxation is most common in investment real estate.
Capital Improvements Will Increase Tax Basis
Improvements to an asset will result in an increase in basis. This is the polar opposite scenario from depreciation. When a person improves a given asset, he or she is investing more resources in the asset. Given that basis is a reflection of investment, it makes intuitive sense that the basis will rise. Of course, improvements will also likely raise the sales price, but this raised price will be offset by the increased basis. Capital improvements are common in real estate investments. For instance, if a person invests heavily in extensive remodeling, these costs may count as capital improvements. The increased basis ensures that a taxpayer will only pay taxes on his or her actual gains associated with a sale.
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