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  • Writer's pictureThe Lincoln Accounting Team

The basics of basis

Basis is a fundamental concept in taxation that plays a crucial role in determining the tax implications of various financial transactions. Whether you're buying or selling assets, gifting property, or inheriting wealth, understanding basis is essential for making informed decisions and optimizing your tax strategy.

Basis refers to the monetary value assigned to an asset for tax purposes. It serves as a starting point for calculating capital gains or losses when you sell, exchange, or otherwise dispose of an asset. In simpler terms, basis helps determine the difference between an asset's selling price and its original purchase price, ultimately affecting the tax you owe on any gains realized.

The most common type of basis is the cost basis, which represents the amount you paid for an asset. This includes the purchase price, along with certain adjustments such as brokerage fees, commissions, and other acquisition costs. The cost basis is typically used for assets acquired through purchase. For example, if you purchase an investment property, basis would include the purchase price, closing costs, title work, and other such costs that put the asset into "service."

When an asset is inherited, the basis is often "stepped up" to the fair market value at the date of the owner's death. This means that the heir's new basis for the inherited asset is its value at the time of inheritance, potentially reducing capital gains taxes when the asset is later sold. This is a good thing that the government has implemented as it means less tax to the heirs, at least in theory.

Adjusted basis takes into account any changes to the original cost basis, such as improvements, depreciation, and deductions. This is especially relevant for real estate and business assets. If you improve an asset (think upgrades on an HVAC system) that would increase basis, if you lose money in any given year within your company, that would decrease basis. Adjusted basis is a continuous cycle and needs to be tracked to determine ending basis upon the sale of the asset.

When you receive a gift, your basis in the gifted asset is usually carried over from the donor's original basis. However, if the asset's fair market value is lower than the donor's basis, special rules apply.

Tax Implications of Basis

When you sell an asset for more than its basis, you realize a capital gain. This gain is subject to capital gains tax, which can be short-term (for assets held for one year or less) or long-term (for assets held for more than one year). The tax rate depends on your income and the type of asset. Conversely, if you sell an asset for less than its basis, you incur a capital loss. Capital losses can be used to offset capital gains, reducing your overall tax liability. If your losses exceed your gains, you may also be able to deduct the excess loss from your ordinary income, up to certain limits.

For assets subject to depreciation or amortization, the adjusted basis is used to calculate deductible expenses over time. This is particularly important for rental properties and business equipment. The stepped-up basis for inherited assets can lead to significant tax savings for heirs. Gifting assets during your lifetime can have different basis implications for both the giver and the recipient, influencing potential tax consequences down the road.

Basis is a fundamental concept that underpins the taxation of various financial transactions. Whether you're buying, selling, inheriting, or gifting assets, understanding the different types of basis and their tax implications is essential for making informed financial decisions. By grasping the intricacies of basis, you can strategically manage your tax liability and potentially maximize your after-tax returns.

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