You already know that taxes are complicated. It’s why so many people pay to have professionals handle their taxes every year. But tax basis calculation is one of the concepts that people tend to have the most trouble understanding.
Part of the problem is that this isn’t an area of taxation that is discussed much. Ask the average person on the street what tax basis is, and they’re likely to give you a clueless expression. Unfortunately, incorrect tax basis calculation can result in you – or your loved ones – losing a huge amount of money.
Let’s take a deeper look into what tax basis is.
Tax Basis 101
Hi. Thanks for stopping by and tuning in for another dose of Bite-Sized Bits of Knowledge, where we give you a meaningful amount of information in a short amount of time. Today we’re going to dive in a little bit more to Income Tax Basis 101. We’ve already kind of talked about the different taxes that are applicable to an estate plan, so today we’re going to talk about Tax Basis 101.
All right, here’s what you got to know. There’s something called Basis or Tax Basis. If you’re familiar with it, skip this video. Or maybe not, because this could be useful.
I’m going to use a concrete example to make this point, but it applies to every asset the same, whether it’s a watch, a boat, a bank account, a business, or whatever. It’s all the same.
Okay. In this example, we’re going to talk about a house. You buy a house for $100,000. Doesn’t matter how you finance it. Your Basis is your purchase price. Your $100,000 Basis is your purchase price. Okay.
Say that you improve the kitchen. You invest $25,000 to improve the kitchen. It’s a beautiful kitchen. Your Basis increases by the amount of that investment. It’s an investment in the fixture of the house. It’s not something you’re taking with you, so it will increase your Basis. This results in what’s called an Adjusted Basis. So your Adjusted Basis is now $125k.
Say that you build a pool. We’re talking about South Florida here. It’s not uncommon. Pool costs $25,000. Your Adjusted Basis increases again from $125k to $150k. Your Adjusted Basis is now $150k.
Then you decide, you know what? I don’t want a pool anymore, and I don’t like my kitchen. So I’m going to sell my house and move into an apartment by the beach. You sell the property for $650,000. It’s a really nice kitchen and it was a really nice pool.
So now you sell it for $650,000. Your gain or loss from a federal income tax perspective is the difference between your purchase price or your sale price of $650k and your adjusted Basis of $150k which, I’m not great at math, is $500,000. Conveniently, a nice round number, $500,000.
So, your gain or loss is plus $500,000 in gain. If it were opposite, it would be a $500,000 loss. But for the purposes of our discussion, we’re talking about appreciation of gain. So we’re going to keep it with the sale price of $650k, Adjusted Basis of $150k or gain. The taxable gain is the margin of difference of $500,000. You’re going to pay or disclose income taxes of $500,000.
Now, there’s a primary residence exception of like $250k per spouse. So you can probably get out of it to a large degree. But I’m not talking about that today. Today, we’re talking about what happens when you are dealing with estate planning.
If you were to give that house to me, because you’re really happy with my work – I’m just kidding. I’m not allowed to accept money or property from a client. Scratch that. Say you give the house to your family member while you’re alive – it’s called an inter vivos gift. They’re going to inherit your Basis. So their Basis is going to be $150k, also. Okay? If they sell it the next day for $650k, then they will have that same $500,000 gain just like you would have had.
Conversely, if you gifted it to them on death, their Basis will not be a carryover Basis. Their Basis will be what’s called a Step Up in Basis. And that means that their Basis will be further adjusted upwards to the date of the value of the property.
So just say, for example, the value of the property was $650k. Their Basis goes from $150k to $650k, which coincidentally is the fair market value. We just said that. So if they were to sell it the next day, their adjusted gain or loss is zero. $650k minus $650k.
Extreme example, overly generalizing everything – do not make decisions based on this. But just understand the concept. This matters. That’s a $500,000 gain or loss difference by just being smart and thoughtful with your planning.
I’m putting aside liability. I’m putting aside gifting. I’m putting aside a lot of other issues just to convey my point about Basis, so please don’t think it’s that simple. It’s not.
So Basis is important. It’s a big part of estate planning now with the exemption being 22-plus million dollars for two spouses. It’s political in nature. There’s been a lot of fighting over trying to get rid of Adjusted Basis and Step Up in Basis. But, for now, this is the rule, and that’s what we do.
So thank you for stopping by. I hope you found this helpful, and stay tuned for more.
Tax Basis Calculation: The Tax Basis of an Asset Is Determined by How It Was Acquired
What does that mean? In short, whether an asset was purchased, inherited, or received as a gift will impact its tax basis.
Let’s look at some examples in more detail to clarify what that means.
Buying a Business. If you purchase a business, each asset in the business will be assigned a tax basis and counted as a portion of the total price you pay.
Receiving a Gift. Gifts are a bit more complicated where tax basis calculation is concerned. First off, tax basis doesn’t come into play unless and until you sell the gift. At that point, your tax basis for the gift will be based on whether you sold if for a profit or a loss. Selling for a profit means the tax basis will be what the previous owner paid for it. Selling for a loss means the tax basis is whichever of these is lower: 1) Market value when you received the gift, or 2) the cost basis of the previous owner. The idea is that this keeps the current owner from benefitting from a loss that happened back when the previous owner had the asset.
Inheriting an Asset. Fair market value at the time of the owner’s death is the tax basis for these types of assets. This means if the asset appreciated in value while the decedent owned it, you won’t be liable for that amount. However, you also can’t claim any losses from the time the decedent was still the owner. If estate tax applies, an alternate valuation date can be used up to six months after the previous owner died. All inherited assets are taxed as long-term capital gains or losses regardless of how long they are held.
Non-taxable Exchanges. You might think that taxes don’t apply to a “non-taxable” exchange such as liquidating a partnership, making a like-kind exchange, or undergoing a corporate reorganization. However, these still have a tax basis. Under the law, it equals the existing tax basis at the time the exchange is made.
Partnership Tax Basis. This is based on the net value of each partner’s:
- Share of Liabilities
- Any income earned
Tax basis will be decreased if there are any distributions.
Stocks and Bonds. Here we get into cost basis versus tax basis. Firstly, cost basis equates to the prices of the stock as well as any commissions and fees. However, this can change over time if distributions are made and any dividends are reinvested. Because of this, the final tax basis can vary greatly from the initial cost basis.
Making Sense of Your Tax Basis for Specific Assets
As you can see, tax basis calculation can easily become quite complicated. This is why working with a trusted advisor can be so valuable. A knowledgeable estate planning attorney can help make sure you plan to minimize the tax burden to you and your loved ones. Don’t wait – get in touch with Haimo Law today.