Income taxes apply to income you earn not just from working, but also from selling or trading assets. However, it’s not as simple as reporting the proceeds from the sale on your income tax return. If you don’t know how to account for your tax basis, you could be overpaying significantly on your taxes. Knowing the significance of the tax basis of your assets, as well as how the basis is calculated in different circumstances, helps you better plan for the tax implications of selling or exchanging items.
Calculating Your Tax Basis
Your tax basis for an asset is generally what it cost you to obtain the item, including any transaction costs. For example, if you buy stock for $850 and pay a $5 transaction fee, your basis is $855. Your basis also includes the value of any non-cash portions of the transaction, such as if your purchase price includes other assets or debts of the seller that you take on. For example, if you trade in a used car worth $5,000 and pay $12,000 cash for a new car, your basis for the new car is $17,000. Similarly, if you are buying a house and you pay $50,000 cash and assume a $100,000 mortgage, your basis for the home is $150,000.
Understanding the Basis of Gifted Property
When someone gifts you property, your basis equals whatever the basis of the person who gave you the property. For example, if your mom bought a house for $180,000 and gifts it to you a decade later, you take the same basis your mom had.
However, if any gift tax was paid on the gift, the basis goes up by the amount of gift tax paid on the transfer, but the basis can’t be increased higher than the fair market value. It’s unlikely that most people will ever have to worry about this rule because of the extremely high lifetime gifting credit. As of 2018, each person can gift $11.18 million during their lifetime before any gifts become taxed. On top of the lifetime exclusion, you also have the annual gift tax exclusion, which allows you to give up to a certain amount, $15,000 as of 2018, to each recipient each year before you even start using your lifetime exemption. For example, if you gave someone a $20,000 car as a gift, assuming you hadn't made any other gifts to that person during the year, the first $15,000 would be excluded under the annual gift exclusion, and your gift would only use $5,000 of your lifetime exclusion.
For example, say that your mom paid $72,000 in gift taxes on the transfer of the gift to you. The gift tax plus her basis of $180,000 equals $252,000. If the fair market value of the house is now $230,000, your basis becomes $230,000 because the amount of the gift tax cannot exceed the fair market value. But, if the fair market value if $300,000, your basis becomes $252,000 because that is the sum of your mom’s basis plus the gift tax paid on the transfer.
Understanding the Basis of Inherited Property
If you inherit property, the rules are much different. Instead of getting the same basis as the person you received the property from, your basis usually becomes the fair market value of the asset on the date that the person died. For example, say that your dad bought stocks for $3,000 and has owned them for decades. To calculate the value of the stocks on the date of death, average the high price and the low price for the date to calculate the share value. If the stock is now worth $10,000, your basis is $10,000 and the $7,000 of gain escapes ever being taxed. If your dad had sold the stock a day before he died for $10,000, he would have had to pay income taxes on that $7,000 gain.
The tax code does provide for an alternative valuation date that certain estates can elect to use to value assets instead of the date of death. If it would reduce the amount of estate tax, the estate can elect to use the value of the assets six months after the date of death instead of the date of death. This election is all or nothing – if the alternative valuation date is elected, it applies for all assets of the estate. However, this election is only available if it would decrease the amount of estate tax due. Given that there are very few estates that will ever have to pay federal estate tax because the exemption is $11.18 million, most estates won’t even have the option to use the alternative valuation date.
One important exception to the step-up in basis at death is for assets that generate income in respect of a decedent. The most notable example if this is distributions from qualified retirement plans, like 401(k) plans and IRAs. When you inherit a plan, the distributions are taxable to you the same way they would have been taxable to the decedent. For example, if your aunt leaves you a traditional IRA, when you take distributions from the IRA, you have to pay taxes on the withdrawals just like your aunt would have had to pay taxes if she took the distributions.
Calculating the Tax Basis for Sales
The most basic application for tax basis of assets is when you’re calculating your gain or loss after you sell an asset. When you sell, the IRS doesn’t charge you income taxes on the entire amount of the sale price. Instead, you only pay income taxes on your profits, which equals your net proceeds minus your basis. For example, say you buy a stock for $2,000 and later sell it for $2,400. It would be unfair to tax you on the entire $2,400 that you received in the sale. Instead, subtract your tax basis of $2,000 from the proceeds of $2,400 to find you’ll only have to report $400 of taxable income from the sale.
Calculating the Tax Basis for Depreciation
Your tax basis for assets also matters for the purpose of calculating the amount of depreciation expenses you can claim each year. Depreciation allows you to deduct the value of an asset over its usable life, instead of deducting the entire amount in the year that you pay for it. The IRS has different recovery periods for different types of assets based on how long those assets typically last. For example, computers and cars are typically depreciated over five years. In addition, when dealing with rental property, you have to allocate the basis between the land and the building. The building is a depreciable asset, but land cannot be depreciated.
For example, if you purchase a rental home for $185,000, you can’t offset $185,000 of income in the year you make the purchase. Instead, first determine how much of the purchase price is for the land and how much is for the home. Based on land values, you might conclude that $110,000 of the purchase price is for the building and $75,000 is the value of the land. Then, because the recovery period for residential rental property is 27.5 years, you divide $110,000 by 27.5 to find that you could deduct $4,000 each year to offset your any rental income generated by the property.
As you claim depreciation deductions to offset income from your property, your basis is decreased by the amount of depreciation you were entitled to claim. Then, when you sell the property later on, you have a larger gain. In addition, the amount of the deductions you’ve taken are treated as ordinary income. For example, if you bought the rental for $185,000 and when you sell it for $200,000, you had taken $30,000 of depreciation, your basis is $155,000 so your gain is $45,000, made up of $30,000 depreciation recapture and $15,000 of capital gains.
Understanding Expensing Versus Capitalized Improvement Costs
During the time you owe an asset, such as a rental property or even your own house, you’re likely to spend some money improving the property. When you improve property, you have to categorize the improvement as either a cost you can deduct fully in that year or a capitalized expense that must be depreciated over several years. Typically, repairs or maintenance costs count as business expenses that you can use to offset rental income – or are lost if it’s your own house. For example, if you have replace one window in your home because a baseball went through it, you can’t add those costs to your basis. However, when the expenses are long-term, such as installing new energy-efficient windows throughout the building, those costs get added to your basis.
For example, say that you paid $150,000 to purchase your home. If you pay $200 to install a new window pane, that won’t affect your basis in the home. But, if you pay $5,000 to replace all of the windows, you can add the $5,000 cost to your basis which will reduce the amount of your taxable gain when you ultimately sell your home. Other examples of repairs that increase your basis include replacing your entire roof, repaving your driveway or installing central air conditioning or heat. Your basis is also increased by the amount you pay for local improvement assessments for things like roads, water connections and sidewalks.
Calculating the Basis of Bargain Purchases
If you get a great deal on a purchase because of great timing or your superb negotiating skills, your basis equals what you paid for the item. For example, say you find home that is part of a decedent’s estate and the family just wants to sell it as fast as possible. If you buy it for $100,000 when it’s really worth more like $180,000 if the sellers had more time to wait for higher offer, your basis is $100,000.
However, if you get a bargain with a reduced purchase price because it accounts for goods or services you provided to the seller aside from the purchase price, you must include the amount of the bargain discount as taxable income and then your basis becomes the fair market value of the item. For example, say that you’ve been doing legal work for someone and instead of accepting a $20,000 check, the client offers to sell you a car worth $50,000 for $30,000. Because the bargain you’re getting is because of other services, you must include $20,000 of income on your tax return, and your basis for the car is $50,000.
Understanding Insurance Reimbursement
If you suffer theft or a casualty loss, such as damage from a hurricane, earthquake, fire or tornado, you might receive reimbursement from an insurance policy. If the insurance proceeds are less than your basis in the asset and the asset is a total loss, you won’t have much to worry about because you won’t be selling it later on and you won’t owe taxes on the reimbursement because it is less than your basis. For example, say you bought a truck for $20,000 and it was stolen. If your insurance company reimburses you $15,000, your reimbursement is less than your basis so you don’t have any taxable income.
If, on the other hand, your reimbursement exceeds your basis, or the asset isn’t a total loss, the tax outcome is different. First, if the reimbursement exceeds your basis, the excess counts as taxable income. For example, if you had a replacement value policy on your car and your insurance company reimburses you $22,000 for the truck, you would report $2,000 of taxable income.
Second, if the asset isn’t a total loss, you must reduce your basis by the amount of the insurance reimbursement. For example, say that instead of being stolen, your truck suffered hail damage and your insurance company paid you $5,000. Your basis in the truck drops from $20,000 to $15,000. If you later sold the truck for $16,000, you would have a $1,000 taxable gain to report on your return.