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An important tax term that everyone should know is “basis”, especially if you’re in real estate. The odds are very high that you will encounter the term sometime during your lifetime, and it can have a profound impact on your tax liability.

Simply stated, “basis” is the monetary value from which a taxable gain or loss is calculated when an asset is sold. For example, you purchase 100 shares of ABC stock for $10 a share. Your basis for those shares of stock is $1,000 (100 x $10). Then, if the stock were sold for $1,500, you’d have a gain of $500, which is determined by subtracting your basis from the sale price. However this is a very simplistic example of basis. Determining basis, as you will see from the following explanation, can be complicated.

Cost Basis – This is the simplest form of basis and is what you originally pay when you purchase stock, other financial securities, a house, rental property, cars, business assets, land, and other assets. However, even cost can be a little tricky as it includes the asset acquisition costs such as: brokerage costs, escrow closing costs, acquisition travel, legal services, title charges, sales tax, etc. So in our earlier example, let’s say you paid a broker $50 to purchase the ABC stock; then your cost basis would have been $1,550.

Adjusted Basis – After purchasing an asset your basis will change, either up or down, if you make improvements to the asset, suffer damage due to casualty losses, or claim business depreciation or amortization. One example of how your basis increases would be purchasing your home and then adding a pool, family room or other improvements; the cost of the improvements would increase your basis. Keep in mind that routine maintenance is not considered an improvement and does not increase your basis in an asset.

Depreciated Basis - An example of when your basis decreases would be a business asset that you are depreciating (deducting as a business expense the cost of the asset over its useful life). In this case, the basis is reduced by the amount of the depreciation you have deducted against your rental or business income. Examples of assets where basis is typically adjusted downward due to depreciation include rental property, business vehicles, tools, business machinery, etc. In some cases, business assets can actually be 100% deducted (expensed) in the year they are acquired, in which case the asset’s basis is reduced to zero.

Inherited Basis – When you inherit an asset, you inherit it at its fair market value (FMV) at the decedent’s date of death. This is because the FMV is included in the value of the estate of the decedent and taxed if the estate’s value exceeds the exemption credit. This is not necessarily the basis for a future sale because there may be subsequent improvements, casualty losses, and perhaps depreciation taken after the inheritance. If the inherited asset was used in business before the inheritance, all prior depreciation is disregarded in the hands of the beneficiary.

Gift Basis – If someone gifts an asset to you, your gift basis generally is the same as the giver’s basis; however, the gift comes with some potential tax strings attached since you’ll also be receiving the giver’s built-in gains at the time of the gift. Thus, unlike inherited basis, you assume the tax liability for built-in gains.

For example, say your aunt gave you 100 shares of stock for which her basis was $1,000. Thus, your basis is $1,000. At the date of the gift, the stock was worth $2,500. You sell the stock for $5,000 a couple of years after receiving it. Your tax gain is $4,000 ($5,000 - $1,000), which includes the $1,500 ($2,500 - $1,000) gain your aunt would have had if she had sold the stock on the date she gave it to you, plus the $2,500 ($5,000 - $2,500) gain from the date you received the stock.

This is called the “gain basis.”

However, there is also the “loss basis” that must be calculated. The loss basis is the lower of:

a) the adjusted basis of the property prior to the date of the gift or

b) its fair market value at the time of the gift.

For example, assume David purchases a property for $100,000. Couple of years later he gifts the property to Raymond when the fair market value is $70,000. Assume no gift tax was paid on the transfer. Assume Raymond sells the property for $60,000. Raymond’s basis is $70,000 (the lower of fair market value or David’s adjusted basis). Therefore, Raymond’s loss is $10,000 ($60,000 - $70,000).

Note that if David had sold the property for $70,000, his loss would have been $30,000, not $10,000. That is because the loss basis rules prevent the person receiving the gift to receive a tax benefit from the decline in the fair market value of the property while the property was held by the person making the gift. The reason is that if this rule didn’t exist, there would be whole another economy created through gifts to shift properties with losses through gifts to others that would benefit from the loss more than the owner.

Also in some cases neither a gain nor a loss is recognized on the sale of the property received by gift because the selling price is less than the basis for gain and more than basis for loss.

For example, assume David purchases a property for $100,000. Couple of years later he gifts the property to Raymond when the fair market value is $70,000. Assume no gift tax was paid on the transfer. Assume Raymond sells the property for $80,000. The application of the gain basis rules produce a loss of $20,000 ($80,000 - $100,000). The application of the loss basis rules produce a gain of $10,000 ($80,000 - $70,000). Therefore, Raymond recognizes neither a gain nor a loss because the sells price or amount realized is between the gain basis and the loss basis.

If the giver paid a gift tax on the property he or she is gifting, then the rules are a bit more complex and not covered in this article.

Determining your basis and the resulting gain or loss when an asset is sold can be complicated, and of course, good records are needed to verify the basis, including improvements and other adjustments in case of an audit or the sale of that asset.

The above technical reference is provided as a courtesy to the reader by David Silkman, CPA, MST, Broker, Silkman & Associates Accountancy Corporation and SilkRoad Realty, Inc. The information is technical in nature, may not include all the details on a particular subject and may require review of the reader’s circumstances by a professional. You should consult with your tax advisor.

David S. Silkman is a CPA, has a Masters in Taxation (MST) and is a licensed real estate broker. He specializes in real estate tax laws and accounting. If you have any questions, please do not hesitate to call him at 310.479.7020 x301, email him atdavid@saacpa.com or visit www.saacpa.com orwww.SilkRoadRealtyInc.com. Thank you.