What is Basis?
What is Cost Basis?
Simply stated, the term "basis" means a dollar amount assigned to an asset as its owner's unrecovered capital investment for tax purposes. This amount is important in a variety of tax contexts, the most significant of which are in connection with depreciation or amortization and sale of the asset. Depreciable and amortizable assets are written off, as deductions against income, in periodic installments over a period of years theoretically corresponding with the asset's useful life. The amount which may be so written off is the capital investment ("basis") in the asset. When a property is sold the sale proceeds are tax-free to the extent of recovery of the seller's capital investment, or "basis." Only the excess of the amount realized over the basis is income (gain). If the amount realized is less than the basis, a loss has been realized, and such a loss may or may not be allowed as a deduction from gross income, as discussed below.
The initial basis of an asset is established upon acquisition of ownership. Usually this is measured by its cost. However there are situations in which an amount other than cost is assigned as an asset's tax basis. These are commonly referred to as "carryover (or "substituted") basis" and "stepped-up basis," and are more fully discussed below. Once an initial basis is established upon acquisition, this amount is subject to upward and downward adjustments intended to reflect changes in the amount still deemed recoverable tax-free in the event of a disposition.
How is Cost Basis Determined
As a starting point, in most instances the taxpayer's basis in property owned is his cost of acquisition in money or other property given up [I.R.C. §1012]. Generally, the cost basis of property acquired includes the amount of any note given in partial or full payment of the purchase price. If real estate is acquired for less than 100 percent cash down, the basis includes the amount of any purchase-money mortgage and/or any prior mortgage taken subject to. This is so even if the purchaser has no personal liability on the mortgage [Crane v. Commissioner, 331 U.S. 1 (1947)]. On the other hand, the debt portion of an acquisition cost would not be included in basis if the debt is contingent or illusory, and therefore, might never really be payable [Albany Car Wheel Co. v. Commissioner, 40 TC 831 (1963), aff'd 333 F.2d 653 (2d Cir. 1964). See Mayerson v. Commissioner, 47 TC 340 (1966)] In the case of property received as compensation for services, the fair market value of the property would be includable in the gross income of the recipient, and this same amount would also become the recipient's cost basis in the property.
Property Acquired In A Taxable Exchange Transaction
The cost basis of property acquired in an exchange for other property given up is equal to the fair market value of the property given up (which, in most cases, will be equal to the value of the property received).
What is Carryover Basis
There are certain situations in which the tax law assigns a basis to property which is other than its cost to the acquiring taxpayer. These generally involve transactions in which property is received from a transferor who was permitted to transfer the property free of tax on his gain. Except in the case of transfers upon death, these transactions do not permanently erase the tax liability on the transferor's gain; they merely allow deferral of the tax consequences by assigning to the property received a basis equivalent to the basis of the property which was transferred without recognition of gain. This is referred to as a "carryover" basis. The carryover basis is used principally for property acquired by gift (where no gain or loss is recognized by the donor) and property acquired in certain exchanges for other property as to which no gain or loss is recognized. Both of these situations are discussed in more detail below. Through the mechanism of the carryover basis, the gain or loss which went unrecognized (upon the transfer by gift or exchange) is effectively built into the property received and will be recognized upon its subsequent disposition.
E receives, as a gift from her grandmother, a coin collection valued at $10,000 at the time of the gift. The collection had a cost basis to the donor of $3,000. Subsequently, E sells the collection to a dealer for $10,000. E has a taxable gain of $7,000, the excess of the $10,000 selling price over the carryover basis of $3,000. It should be noted that even though E realized no economic gain during the period that she owned the collection (since she sold it for the same amount as it was valued when she received it), she must recognize a tax gain of $7,000. Because the collection carried over the donor's $3,000 basis, the $7,000 of appreciation which had accrued during the period of the grandmother's ownership but was not recognized at the time of the gift transfer, became a recognized gain upon the sale by E.
Property Acquired By Gift
Property acquired by outright gift obviously has no cost to the recipient. (Under I.R.C. §102 property acquired by gift is not included in gross income of the recipient.) However, it does have a carryover basis for tax purposes. The basic rule is that property transferred by gift (other than at death) carries over to the recipient the same basis it had in the hands of the donor as of the time of the gift [I.R.C. §1015]. The rule is altered, however, in the event that the carryover basis is greater than the fair market value of the property at the time of the gift. In such circumstances the basis for purposes of determining loss on a future disposition is deemed to be the market value at the time of the gift. This alternative basis principle in the case of gifts is illustrated by the following example in Reg. §1.1015-1(a)(2):
Adam acquires by gift income-producing property which has an adjusted basis of $100,000 at the date of gift. The fair market value of the property at the date of the gift is $90,000. Adam later sells the property for $95,000. In such case there is neither gain nor loss. The basis for determining loss is $90,000; therefore, there is no loss. Furthermore, there is no gain, since the basis for determining gain is $100,000.
To the extent that a gift tax must be paid in connection with a transfer of property, the amount of the gift tax attributable to any appreciation in value over the basis carried over may be added to the recipient's carryover basis in the property [I.R.C. §1015(d)(6)].
Property Acquired In A Tax-Free Exchange
In certain situations special Code provisions require exchanges of property, which would otherwise give rise to taxable income, to be concluded without tax consequence at the time of the exchange. The policy is to permit deferral of the tax by requiring that the property received take as its basis the same basis as the property given up (in lieu of the normal measure of basis, which would be the value of the property given up) by the transferee to acquire the property received.
H has a parcel of land with a basis of $80,000 and a value of $90,000. He exchanges his parcel in a tax-free exchange for B's land which has a value of $90,000. The cost basis of the land received by H in the exchange would have been $90,000 (the value of the property given up), but because the transaction was a tax-free exchange, H must carryover to the new property the $80,000 basis of the property given up.
Basis Adjustments When Taxable "Boot" Received
The carryover basis of property received in a tax-deferred exchange is subject to certain adjustments if the exchange involves "boot." In the foregoing example assume that instead of receiving land with a value of $90,000, H receives land with a value of $75,000 and $15,000 in cash. The $15,000 in cash is treated as boot, and since the boot exceeds the $10,000 realized gain, the entire gain would be recognized. The basis of the property received in the exchange would be $75,000 (carryover of basis of original property, $80,000; increased by the gain recognized, $10,000; and reduced by the amount of boot received, $15,000). Tax deferred exchanges, pursuant to I.R.C. §1035 (dealing with insurance policies) and §1031 (dealing with real estate), are discussed in detail later in this Subdivision.
Property Transferred In Trust
If property is transferred in trust as a gift, the carryover basis rules for gifts, discussed above, apply. Thus, if the property is later sold by the trust, the basis for computation of gain will be the grantor's basis, as carried over, and the basis for computation of loss will be the market value as of the date of transfer in trust.
Property Acquired Incident To Divorce
I.R.C. §1041 provides non-recognition treatment for gains and losses realized when property is transferred between spouses or between ex-spouses when the transfer is incident to a divorce. For basis purposes, such transfers are treated the same as gifts; the basis in the hands of the transferee is the adjusted basis of the transferor [I.R.C. §1041(b)].
Stepped-Up Basis; Property Transferred Upon Death
In general, the term "stepped-up" basis refers to situations in which a basis amount (often a carryover basis) is adjusted upward, which is ordinarily to the taxpayer's advantage (e.g., it reduces potential taxable gains on future sale and it increases potential depreciation deductions). Of course, whenever property is transferred in a taxable transaction, the basis in the hands of the purchaser is in effect "stepped up" from the seller's former basis to the amount paid by the purchaser (presumably fair market value), although, as discussed above, we refer to the purchaser's basis as a "cost" basis. There are some circumstances in which basis can be stepped up even without a transfer of the property; e.g., a partnership may step up the basis of its assets when a partner is required to report a gain in connection with the sale of his partnership interest [see I.R.C. §754].
The most significant application of the step up in basis is the tax-free step up permitted upon the death of a property owner. Thus, when one individual dies, any property which she owned at the time of her death (and is therefore includable in her gross estate) takes on a new basis, in the hands of the estate or the heirs who inherit the property, equal to the fair market value at the date of death (or alternate valuation date) [I.R.C. §1014]. While it is true that if the fair market value of property for federal estate tax purposes (on the date of death or alternate valuation date) is less than the decedent's basis, the basis will have to be stepped-down, in the vast majority of cases the date-of-death value will be higher than the decedent's basis. Thus, the step-up in basis upon death is probably the most significant "loophole" that exists in the federal income tax system, and it is of enormous importance in financial and estate planning.
35 years ago H started a small retail business. He incorporated the business with a $1,000 investment, and has always owned 100 percent of the stock. After years of hard work, H's business grew to ten stores and his stock in his company was worth $10 million. If H were to sell his stock, he would face a taxable gain of $9,999,000. If H wanted to retire and give the stock to his son, S, the original $1,000 basis from 35 years earlier would carry over and become S's basis in the stock, and S would face the same potential $9,999,000 gain if he later wanted to sell. But if H were to die and S were to inherit the stock, S would take a stepped-up basis equal to the $10 million value on H's death. In such cases, because the stock was transferred by reason of death, the entire amount of appreciation in value accumulated over 35 years permanently escapes income tax. (Note that this escape from income tax through basis step-up on death has no bearing on estate tax liability, which is generally based upon property values at the date of death (or alternate valuation date.)
Cost Basis Consideration In Planning Family Gifts
A common estate planning technique is to reduce the size of the gross estate which will ultimately be taxed when the taxpayer dies, by making annual gifts during the taxpayer's lifetime. Although gifts are generally subject to a gift tax, there is an important exception which permits tax-free gifts of up to $15,000 (as indexed in 2019) per donee per year, without limit on the number of donees.
In planning for gifts of property, if the donor has a choice among more than one type of property to be transferred as the gift(s) (e.g., if she has a portfolio of several investment securities), it would probably be more advantageous, for tax purposes, to transfer assets having less unrealized appreciation (i.e., current value in excess of basis). This general concept, which becomes more compelling the greater the age of the donor, is premised on the fact that the assets still owned when the donor dies will take a stepped-up basis, thereby permanently eliminating income tax on all unrealized appreciation. Thus, if there is a choice, the family will be better off in the long run if the assets which are transferred as gifts are those with the least unrealized appreciation. Not only will this minimize the income tax cost to the donees upon liquidation of the property for cash, but, more importantly, by retaining until death those assets with the greatest unrealized appreciation, the donor will maximize the benefit to be derived from the stepped-up basis loophole.