Basis is a common term to the IRS, but one that probably does not enter into your everyday conversation. Understanding what it means, however, can have an impact on the taxes you pay.
Per the IRS;
Basis is generally the amount of your capital investment in a property for tax purposes. Use your basis to figure depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange or other disposition of the property.
In plain language, basis is the collection of tax rules that establishes the cost of your property. Once the tax basis is established, you can then apply that basis to determine whether there is a gain or loss on your property when it is disposed, exchanged or sold. Unfortunately, it is not quite that easy. There is also Cost Basis, Adjusted Basis, and Basis other than cost.
Cost basis. Your basis usually starts with what the item cost. But cost basis also includes sales tax paid, freight, installation, testing, legal fees and other fees to purchase the property. If you purchase a business you must allocate the cost to each of the assets purchased.
Tip: Retain records of any major transaction. Ensure the documentation includes all allowable costs. This will help reduce gain taxes when you sell or dispose of the property.
Adjusted basis. When you sell, exchange or dispose of property you may have to adjust the basis of the property for tax purposes. This is known as Adjusted Basis. The most common example of adjusting basis is improvements having a useful life for more than one year. But Adjusted Basis can decrease the value of property as well. This might include things like casualty or theft losses, depreciation and other deductions.
Home tax tip: Adjusted basis applies to many home improvements. This could include full roof replacement, adding a room to your home, or even special assessments for local improvements. Create a folder and retain all documentation that could add to your home’s basis. It may lower your capital gain when you sell your home.
Basis other than cost. What is the basis when you receive property for services or you inherit stock, or you receive property as a gift? In most cases basis becomes the fair market value (FMV) of the item. This is the price a willing buyer would pay for the item and a willing seller would be willing to receive for that item. But there are also special basis rules for:
- Inherited property
- Like-kind exchange of property
- Involuntary conversions
- Property transferred to a spouse
Should any of these situations apply to you, please ask for a review of your circumstance as establishing basis can become fairly complex.