Many of us have had the same experience with doctors and other health professionals. They are explaining an issue and suddenly the big Latin words start creeping in, leaving those of us not in the medical field baffled. It is easy for a professional to slip into the language of their field, including accounting professionals. However, there are several tax concepts that it is essential for clients to understand – which means it is essential that we explain these in a way they can comprehend. Basis is one of these basic tax principles in which every person should have at least basic knowledge.
Basis of Earned or Purchased Property
In most cases, the basis of purchased property is what the purchaser paid for it. With property given in exchange for services or otherwise earned, it is a bit more complex. In most cases, the basis will be the fair market value, or FMV, on the date that the property is received. Ideally this should be agreed on before the property is transferred.
Basis is much the same when property is inherited or given as a gift. The basis of a gift is generally either the FMV of the property on the date it was given or the basis that the giver was using for tax purposes. Both bases should be tracked as they can be important in claiming gains and losses. The basis of inherited property is treated similarly, with the most common means of calculating it being the FMV on the date of the decedent, the date of alternative valuation (which occurs six months after the death), or the date that the property was disposed.
If the property is being inherited by a spouse in a community property state, the spouse will receive a “step up” – that is, the adjusted basis of the half of the property they already owned plus one half the FMV as the inherited half.
Changes to the Basis: A Primer
It is easy to see why clients might be confused by even the basics of basis, but the subject becomes more clouded when exchange is calculated. When a property is transferred, it is often done so via tax-free §1031 exchange. The new basis is then the former basis minus any costs of the exchange. In addition, the basis can be adjusted if items that are not cash, or “unlike property,” were exchanged at the same time.
Once the property has been completely exchanged, the basis will decrease with tax-deductible costs of improvements and increase with costs that are not written off. Depreciation and casualty losses also can decrease the basis. Last, any payments made for easements and other property access are deducted from the basis.
As you can see, this simple legal concept becomes extremely complicated once the IRS is involved. This is one of many reasons that even everyday people need quality accounting help. Making a mistake in calculating basis and changes to basis can be an expensive mistake. CPAs are trained in handling these calculations and using them to get the most out of property.