There’s Nothing Basic about Tax Basis: Personal Property & Brokerage Accounts

What exactly is basis, and why is it so essential to understand the difference between cost basis and adjusted basis? This information is crucial for tax planning whether you are buying, owning, selling, gifting, or estate planning.

Let’s start with the basics. Basis is broken down into two very distinct but related methods: cost basis and adjusted basis. Cost basis is defined as the amount of your original investment in an asset for tax purposes. For example, if Jane were to purchase a home for $100,000, then the cost basis is $100,000. Now, let’s say she wants to build a deck that will cost $25,000. Therefore, her home’s cost basis of $100,000 plus the improvement of $25,000 equals $125,000. The $125,000 is now Jane’s adjusted basis and will be used if she were to sell the home or gift it. The adjusted basis is the value of an asset used when determining the gain or loss when selling the asset.

Why is the difference between these two important, and why should your tax preparer know when you plan to dispose of an asset? The answer is that knowing the difference between the two can help you recover your purchase cost plus any improvements you made to the asset tax-free.

To illustrate further, individuals often invest in assets such as a personal home, a rental property, stock in an investment or retirement portfolio, or real estate.  The cost basis for these will represent their initial value at the beginning of the investment; the adjusted basis will reflect the changes during the life of the investment and ultimately impact the value at the time of the sale or transfer. Cost basis can be even more important if a property is acquired not by purchase but as a gift or an exchange. 

Believe it or not, even life insurance policies, as long as they are not term life insurance policies, have a cost basis and an adjusted basis if you were to transfer or sell the policy.

So how do you calculate the cost basis? It’s simple. When a taxpayer purchases or exchanges a property, the following items are included in a cost basis:

o   The purchase price or value of the asset received during an exchange

o   Sales tax and real estate property tax that the seller owes

o   Freight/shipping cost 

o   Recording fees if applicable 

o   Legal fees 

o   Accounting fees related to depreciable assets 

o   Real estate taxes (amount assumed on behalf of the seller) · Installation cost 

o   Excise tax  

Once the cost basis is calculated, the basis can be increased to a calculated adjusted basis.

The basis is increased for: 

o   Any capital improvements such as a new roof, fixing driveway, replacing any equipment 

o   Cost of repairing any property that is damaged 

o   Zoning costs 

When you sell an investment such as brokerage accounts or assets such as primary residence, the tax consequences are calculated as Sale Price – Adjusted Basis = Net Gain/(Loss). The Net Gain or Net Loss is either taxed as ordinary income if the property is held less than 1-year or capital gain or loss if held for more than one year. 

You can see how determining the adjusted basis of an asset accurately can have significant implications on the tax bill!  

With this blog, we wanted to provide an initial introduction to the shared importance of basis and why it is necessary for taxpayers when they dispose of an asset or liquidate their investment.

We will discuss basis rules for property received via gift, inheritance, or exchange in a separate blog along with any business investments such as rental properties or other real estate investments.

Sources:

https://www.irs.gov/pub/irs-pdf/p551.pdf