Tax Basis Definition and Why Is It So Important?

Tax Basis Definition and Why Is It So Important?

For tax purposes, the term “basis” refers to the monetary value used to measure a gain or loss.


Tax Basis Definition 

For tax purposes, the term “basis” refers to the monetary value used to measure a gain or loss. For instance, if you purchase shares of a stock for $1,000, your basis in that stock is $1,000; if you then sell those shares for $3,000, the gain is calculated based on the difference between the sales price and the basis: $3,000 – $1,000 = $2,000. This is a simplified example, of course—under actual circumstances, purchase and sale costs are added to the basis of the stock—but it gives an introduction to the concept of tax basis.



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The basis of an asset is very important because it is used to calculate deductions for depreciation, casualties, and depletion, as well as gains or losses on the disposition of that asset. 

The basis is not always equal to the original purchase cost. It is determined in different ways for purchases, gifts, and inheritances. In addition, the basis is not a fixed value, as it can increase as a result of improvements or decrease as a result of credits claimed, business depreciation, or casualty losses. This article explores how the basis is determined in various circumstances.


What does Cost Basis mean?

The cost basis (or unadjusted basis) is the amount originally paid for an item before any improvements and before any credits, business depreciation, expensing, or adjustments as a result of a casualty loss. 


What is Adjusted Basis?

 The adjusted basis starts with the original cost basis (or gift or inherited basis), then incorporates the following adjustments: 

  • increases for any improvements (not including repairs), 
  • reductions for tax credits claimed based on the original cost or the cost of improvements,
  • reductions for any claimed business depreciation or expensing deductions, and
  • reductions for any claimed personal or business casualty-loss deductions. 

Example: You purchased a home for $250,000, which is the cost basis. You added a room for $50,000 and a solar electric system for $25,000, then replaced the old windows with energy-efficient double-paned windows at a cost of $36,000. You claimed tax credits of $7,500 and $200, respectively, for the solar system and windows. The adjusted basis is thus $250,000 + $50,000 + $25,000 - $7,500 + $36,000 - $200 = $353,300. Your payments for repairs and repainting, however, are maintenance expenses; they are not tax-deductible and do not add to the basis.

Example: As the owner of a welding company, you purchased a portable trailer-mounted welder and generator for $6,000. After owning it for 3 years, you then decide to sell it and buy a larger one. During this period, you used it in your business and deducted $3,376 in related deprecation on your tax returns. Thus, the adjusted basis of the welder is $6,000 – $3,376 = $2,624.


See this related post from Dennis Harabin: Tax Benefit: The Difference Between Tax Deduction and Tax 
Tax lingo, even without getting into the weeds of the Internal Revenue Code, tax regulations, IRS rulings, etc., can be confusing. Two frequently used terms that taxpayers sometimes think provide the same tax benefit, but don’t, are “tax deductions” and “tax credits.” Although a tax deduction and a tax credit both help lower the taxpayer’s tax, there’s a difference between them, and there are distinct types of deductions and categories of credits. This article explains these terms. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.  

Keeping records regarding improvements is extremely important, but this task is sometimes overlooked, especially for home improvements. Generally, you need to keep the records of all improvements for 3 years (and perhaps longer, depending on your state’s rules) after you have filed the return on which you report the disposition of the asset. 


Gift Basis 

If you receive a gift, you assume the donor’s (giver’s) adjusted basis for that asset; in effect, the donor transfers any taxable gain from the sale of the asset to you. 

Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. However, your mother originally purchased the shares for $5,000. You assume your mother’s basis of $5,000; if you then immediately sell the shares, your taxable gain is $15,000 – $5,000 = $10,000.

There is one significant catch: If the fair market value (FMV) of the gift is less than the donor’s adjusted basis and you then sell it for a loss, your basis for determining the loss is the gift’s FMV on the date of the gift. 

Example: Again, say that your mother purchased stock shares for $5,000. However, this time, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. In this case, your tax-deductible loss is only $1,000 (the sales price of $3,000 minus the $4,000 FMV on the date of the gift), not $2,000 ($3,000 minus your mother’s $5,000 basis).


Inherited Basis 

Generally, a beneficiary who inherits an asset uses the asset’s FMV on the date of the owner’s death as the tax basis. This is because the tax on the decedent’s estate is based on the FMV of the decedent’s assets at the time of death. Normally, inherited assets receive a step-up (increase) in basis. However, if an asset’s FMV is less than the decedent’s basis, then the beneficiary’s basis is stepped down (reduced). (Congress has been considering a change that would make the inherited basis the amount of the decedent’s adjusted basis, thus eliminating the beneficial step-up in basis rule. Please check with this office for the current status of the legislation.)

Example: You inherited your uncle’s home after he died in 2020. Your uncle’s adjusted basis in the home, which he purchased in 1995, was $50,000, and its FMV was $400,000 when he died. Your basis in the home is equal to its FMV: $400,000.

Example: You inherit your uncle’s car after he died in 2020. Your uncle’s adjusted basis in the car, which he purchased in 2015, was $50,000, and its FMV was $20,000 at his date of death. Your basis in the car is equal to its FMV: $20,000.



See this related post from Dennis Harabin: How Does Gift Tax Work?
Frequently, taxpayers think that gifts of cash, securities, or other assets they give to other individuals are tax-deductible; in turn, the gift recipient sometimes thinks income tax must be paid on the gift received. Nothing can be further from the truth. To fully understand the ramifications of gifting, one needs to realize that gift tax laws are interrelated with estate tax laws, and Uncle Sam does not want you giving away your wealth before you pass away to avoid the estate tax.

FMV calculator

An inherited asset’s FMV is very important because it is used to determine the gain or loss after the sale of that asset. If an estate’s executor is unable to provide FMV information, the beneficiary should obtain the necessary appraisals. Generally, if you sell an inherited item in an arm’s length transaction within a short time, the sales price can be used as the FMV. 

A simple example of a transaction not at arm’s length is the sale of a home from parents to children. The parents might wish to sell the property to their children at a price below market value, but such a transaction might later be classified by a court as a gift rather than a bona fide sale, which could have tax and other legal consequences.

For vehicles, online valuation tools such as the Kelly Blue Book can be used to determine FMV. The value of publicly traded stocks can similarly be determined using website tools. On the other hand, for real estate and businesses, valuations generally require the use of certified appraisal services.

The foregoing is only a general overview of how the basis applies to taxes. If you have any questions, please call this office at 551-249-1040 for help.

Dennis Harabin at Relax Tax is an expert in taxes, insurance, and debt. Contact him today!



Recommended Readings:

  • Tax Benefit: The Difference Between Tax Deduction and Tax
  • How Does Gift Tax Work?
  • Tax Credits You Might be Missing
  • A Special Tax Benefit for Inheritances to Enjoy
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