If you want to become a more financially responsible adult, one thing you need to learn and understand as an adult is taxes. It’s something you can’t escape, so you might as well dive in and learn more about it because it’s knowledge that will definitely come in handy one day. When learning and understanding taxes, you also need to learn about tax basis and its importance. When referring to taxes, the word “basis” refers to the initial monetary value used to measure a loss or gain.
For example, imagine that you bought $1,000 worth of stock. So, this means that your basis would be $1,000. If you choose to sell your share for $3,000, you can calculate the gain based on the difference between the basis and the sales price. In this case, it would be $2,000 because $3,000 – $1,000 = $2,000. Of course, this is just a basic example, and when you’re actually running a business or buying stock, there are other factors you need to consider. Still, this serves as a great introduction to the idea of what tax basis is.
It’s important to fully understand the basis of an asset because you’ll need it when calculating deductions for depreciation, depletion, casualties, losses, gains, and more. That being said, you can’t assume that the basis is always equal to the initial cost of the purchase. It depends on whether it’s a gift, inheritance, purchase, etc. Not only that, an asset’s basis isn’t fixed—it can either increase if it has undergone improvements or decrease due to losses or depreciation.
Below, we’ll explain how the basis differs depending on the circumstance.
First and foremost, we have the cost basis (otherwise known as the unadjusted basis). This is what you start with because cost basis refers to the amount you initially paid for something you purchased before any adjustments, improvements, or depreciation has occurred.
When you receive something as a gift, this means you assume the gift giver’s adjusted basis for the asset that was given to you. Consequently, any taxable gain from the asset will be transferred to you, as well. Let’s have another example: let’s say that your uncle offered you stock shares worth $15,000 during the time it was given to you. However, the initial price your uncle bought the stock for was around $5,000. This means that you’ll get to assume the basis of $5,000, but if you choose to sell the stock shares immediately, your taxable gain would be $10,000 because $15,000 – $5,000 = $10,000.
As a general rule of thumb, if you inherit an asset, you use the same FMV as when the initial owner passed away as the tax basis. This is because the tax on the deceased’s estate is based on the same FMV as the assets during the time of passing. Typically, assets that are inherited receive an increase in basis, otherwise known as the stepped-up basis. But if the FMV of the asset is lower than the basis of the deceased, the beneficiary’s basis would consequently be reduced.
Lastly, there’s the adjusted basis, which begins with the initial cost basis (or inherited basis or gift basis, depending on your situation). After that, these adjustments are made to the basis:
- There’s an increase if any improvements have been made.
- There’s a reduction if there is business depreciation or any deductions.
- There’s a reduction if there are casualty-loss deductions and the like.
This is only a general look at tax basis and the different possible circumstances that come with it, and we hope that you were able to learn something vital from this article.