(For a discussion of the tax treatment of the sale and trade of property, see here.)
When you sell property, you’ll either have a gain or loss. The lingo associated with this gain or loss is not always intuitive, but is necessary for understanding the overall taxability of the transaction. In that vein, this post acquaints the reader with some of the language necessary to read tax literature and determine gain or loss from the sale of property. More specifically, this article focuses on the basis of property and how to determine basis both initially and through adjustment.
The first variable in the determination of gain or loss in the sale of property is the basis. A basis can generally be thought of as the purchase price, but it also encompasses several other factors. Aside from purchase price, the initial basis can also include taxes and professional fees. It’s also irrelevant whether you pay cash or take out a purchase money loan to buy the underlying asset because both are equivalent when it comes to determining basis. For example, you can borrow $200,000 to buy a rental house that costs $200,000 and have a basis of $200,000 in the property. It doesn’t matter that none of your own money went into initially purchasing it.
Frequently, events will occur that cause the basis in your property to change from what it was initially. These changes are called adjustments. For example, if you depreciate your real estate rental property that has an accompanying basis of $200,000, the depreciation can be deducted against the rental property’s income in that tax year. However, that depreciation is not free; you have to reduce the basis in the property by the amount of depreciation you took. So if you depreciated the property by $3,500 and took that as a deduction against rental income, you would also have to decrease the basis by $3,500. Therefore, all other things being equal, you would have an adjusted basis of $196,500 ($200,000 minus $3,500). Similarly, there are also events that can cause the basis in property to increase, like adding a room onto a rental house, in which the upward adjustment would most likely be equivalent to what the extra room cost you.
What if you don’t pay a monetary price for property, such as an exchange of property? Under those circumstances, the basis in the property you receive is generally the fair market of the property at the time of the exchange. This also applies to instances where you pay less than the value of the property in payment for services you provide. In that case, you include the difference between the fair market value and the price paid as income on your return, and your basis in the property is, again, the fair market value.
Additionally, in the case of an involuntary conversion, which essentially means that property is taken from you without your consent, such as theft, the basis in your replacement property is the same as the basis in the original converted property, minus any loss recognized or money received and not used to purchase the replacement, or plus any gain recognized or additional money put into the replacement, depending on the specifics of the situation. For example, if there’s a fire at my rental house, and I have a basis of $100,000 and I get an insurance payout of $100,000 but it only costs $90,000 to rebuild the house, then my basis is $90,000 because according to the rule I have to subtract the $10,000 not spent on rebuilding.
What’s more, you may have heard of so-called like-kind exchanges under section 1031. A like-kind exchange occurs when you trade property of a similar nature used for business purposes with someone else. Generally the basis in the property you receive is the same as the property that you are giving up, plus any money that changed hands as a result of the transaction. For instance, if you traded a $100,000 house used for rental purposes plus you gave the other party $10,000 in cash, and he traded you a house also used for rental purposes, then under the rule, you would have a basis of $110,000, or the basis in the property you just traded, plus the amount of cash you contributed. Note that the purpose of this property has to be business, and furthermore, a business purpose other than the sale of that property. Also, the property can be either real or personal, but the exchange can only be between property that is both similar in nature and purpose. Therefore, you can’t trade personal property for real property, even if it’s of equivalent value, and call it a like-kind exchange.
Next, if property is transferred from one spouse to another, then that property will retain the basis that the transferring spouse had right before transfer. This rule also applies to property transfers that are between ex-spouses, but only under color of a valid divorce decree.
When determining the basis of gifts, it all depends initially on whether the fair market value of the property at the time of the donation to the recipient is greater or less than the donor’s (the giver’s) adjusted basis. For gifts that have a fair market value that is less than the value of the donor’s adjusted basis, and there is a loss at the time you, the donee, eventually dispose of the gift property, use the fair market value plus any adjustments, up or down. However, if there’s a gain at the time you eventually dispose of the gift you received from the donor, then use the donor’s adjusted basis, plus any adjustments that have accrued over the period of time you held the property.
Looking at the opposite scenario, if the gift you receive has a fair market value greater than the donor’s adjusted basis, then use the donor’s adjusted basis as your basis, and make any adjustments to basis, either up or down, for occurrences during your ownership of the property. Also, increase your basis by the amount of gift tax paid, if any, multiplied the ratio of the donor’s gain in the property over the value of the gift above the annual exclusion, which currently sits at $15,000.
What’s more, if you inherit property either through a will or through intestate succession, then the basis in the property you receive is its fair market value at the time the decedent passed away. This tax benefit is called a step up basis. This is also true between spouses in community property states. That is, the basis in the property when one spouse dies and leaves it to the other spouse, is the fair market value of the entire piece of property, not just the decedent’s half.
Additionally, if you use property initially for personal use and then after a while change its use to that of only business, such as the conversion of your primary residence to a pure rental house, then the basis you assign to that converted property is the lesser of the fair market value on the date of the change or the adjusted basis at that time.
Finally, for stocks and bonds the basis is usually whatever amount you initially paid for them. However, if you didn’t pay for those investments, then your basis is either the fair market value of the stock or the basis of the person you received the stock from, depending on the situation. So, for example, if you received stock as a gift, then your basis would depend on whether you eventually sell the stock at a loss or a gain as was previously discussed in this post. However, if you inherited bonds from your brother after he passed away, the bonds’ basis would be their fair market value at the time of your brother’s passing. Therefore, the basis of stocks and bonds depends on the details of the event that lead to their acquisition.
For more information on basis and adjusted basis see IRS Publication 17.
If you are having issues determining the basis of your property, or have any other tax problems, please call Dino Tax Co today at (713) 397-4678 or email firstname.lastname@example.org. The first phone consultation is free. Also, consider liking Dino Tax Co on Facebook at www.facebook.com/dinotaxco.