The Importance of Basis Explained

Basis can be a complex topic. It is extremely important to understand, as it is how you determine your gain or loss on the sale of property. There are three different types of basis that you may need to calculate and track for your property: cost basis, adjusted basis, and depreciable basis. Each type needs to be calculated in a particular manner.

Cost Basis 

The cost basis of a property is the original amount (cost) you paid for the property, which is increased by most costs that are incurred to place the property into service. This includes most closing costs, legal fees, and other costs to acquire the property. If the property is under construction, then costs such as interest and real estate taxes are capitalized.  Soft costs such as design fees, advertising fees, and engineering fees are also capitalized when the property is under construction.

Adjusted Basis 

Once the property is placed into service, the only way the basis can be increased is through capital expenditures and improvements. Capital improvements do not mean your normal repairs and maintenance expenses. Capital improvements must increase the quality of the property, extend the useful life of the property, restore the property’s value, or adapt the property to a new or different use. The increased basis taking into account your capital expenditures and improvements is your adjusted basis, which is used to compute a capital gain or loss when the property is sold.

Depreciable Basis

You may be required to determine the depreciable basis of an asset, such as a building. This can be particularly important with real estate transactions. Since land is not a depreciable asset, the value of any land is not included in the depreciable basis of the asset. Depreciable basis is the adjusted basis less accumulated depreciation and the value of any land.

1031 Like-Kind Exchanges 

IRC Sec. 1031 exchanges are considered like-kind exchanges for business/investment real property. In a 1031 exchange, an intermediary holds the proceeds from the sale of an investment property and uses them to purchase another investment property for the seller. The seller is able to defer any capital gains from the sale of the property by reinvesting in a qualified property. Both the property exchanged and received must be real property used in a trade or business or held for investment in order to be qualified property.

The basis of the property received in the like-kind exchange depends on if there is any cash or debt relief received or paid along with the property. If there is no cash or debt relief received or paid, then the basis of the received property is equal to the exchanged property’s basis. However, if there is cash or debt involved along with the property, the cost basis of the new property will be adjusted accordingly.

Cost Basis of Inherited Property

The cost basis of inherited property is usually the fair market value (FMV) of the property at the decedent’s date of death.

There is also an alternate valuation date if validly elected by the executor. If elected, the cost basis is the fair market value (FMV) at the earlier of:

1. the distribution date of the property, or
2. six months after the death of the previous owner.

However, this is only allowed if the alternate valuation date lowers the entire gross estate property and estate tax. While this can be beneficial for lowering an estate tax bill, it also means that the person inheriting the property will have less of a “step-up” in basis when the FMV is more than the decedent’s basis at their date of death. All inherited property is considered long-term property when inherited no matter the holding period.

Cost Basis of Gifted Property 

The cost basis of gifted property is usually the adjusted basis that the donor had in the property at the time of gifting. However, if the fair market value is lower than the basis at the date of gifting, the basis may depend on the future selling price of the property. There are three scenarios that can happen when determining the cost basis for the sale of gifted property with lower FMV at the date of gifting:

1. If you sell the gift at a price higher than the donor’s basis, the donor’s basis is used to determine the gain.
2. If you sell the gift lower than the lower FMV at date of gift, the lower FMV at date of gift is used to determine loss.
3. If you sell the gift for less than the donor’s basis but more than the lower FMV at date of gift, then there is no gain or loss.

Conclusion

Although this may seem like a simple process, property held over long periods of time or for use in a trade or business may need significant adjustments to determine its basis. Taxpayers who are engaging in the sale of property should consult with a trusted tax advisor so that nothing is overlooked.