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Chapter 14. Basis of Property Introduction This chapter discusses how to figure your basis in property and covers the following topics: ∙ Cost basis of property you purchase. ∙ Adjustments to basis after you acquire property. ∙ Property you acquire because of a casualty or condemnation. ∙ Property you receive in exchange for your services. ∙ Business or investment property you acquire in an exchange or trade-in. ∙ Property you receive as a gift. ∙ Property transferred to you because of a divorce. ∙ Property you inherit. ∙ Stocks, bonds, and mutual funds. Basis is a way of measuring your investment in property for tax purposes. Use the basis of property to figure the deductions for depreciation, amortization, depletion, and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property. You must keep accurate records of all items that affect the basis of property so you can make these computations. Related publications. This chapter refers to other publications you may need. For more information, you may want to order the following: Publication 448, Federal Estate and Gift Taxes Publication 525, Taxable and Nontaxable Income Publication 537, Installment Sales Publication 550, Investment Income and Expenses Publication 551, Basis of Assets Publication 564, Mutual Fund Distributions Publication 917, Business Use of a Car Cost Basis The basis of property you buy is usually its cost. The cost is the amount of cash you pay for it and the fair market value of other property or services you provide in the transaction. Your cost also includes amounts you pay for: 1) Sales tax charged on the purchase, 2) Freight charges to obtain the property, and 3) Installation and testing charges. In addition, the cost basis of real estate and business assets will include other items. Loans with low or no interest. If you buy property on any time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, less the amount considered to be unstated interest. You generally have unstated interest if your interest rate is less than 9% compounded semi-annually. For more information, see Unstated Interest in Publication 537, Installment Sales. Real Property If you buy real property, certain fees and other expenses you pay are part of your basis in the property. Assumption of a mortgage. If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property in cash plus the unpaid mortgage you assume. Settlement fees and other costs. Legal and recording fees are some of the settlement fees or closing costs that are included in the basis of property. Some others are: 1) Abstract fees, 2) Charges for installing utility services, 3) Surveys, 4) Transfer taxes, 5) Title insurance, and 6) Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions. You must reasonably allocate these fees or costs between land and improvements to figure the basis for depreciation of the improvements. Settlement fees do not include amounts placed in escrow for the future payment of items such as taxes and insurance. Real estate taxes. If you buy real property and agree to pay taxes the seller owed on it, the taxes you pay are treated as part of the cost. You cannot deduct them as taxes paid. If you reimburse the seller for taxes the seller paid for you, you can usually deduct that amount. Do not include that amount in the cost of the property. Adjusted Basis Before you can figure any gain or loss on a sale, exchange, or other disposition of property, or figure allowable depreciation, depletion, or amortization, you must usually make certain adjustments (increases and decreases) to the basis of the property. The result of these adjustments to the basis is the adjusted basis. Increases to Basis The basis of any property is increased by all items properly added to a capital account. This includes the cost of any improvements having a useful life of more than one year and amounts spent after a casualty to restore the damaged property. Other items added to the basis of property include the cost of extending utility service lines to the property and legal fees, such as the cost of defending and perfecting title. Improvements. The cost of improvements that add to the value of property, lengthen its life, or adapt it to a different use is added to your basis in the property. For example, putting a recreation room in your unfinished basement, adding another bathroom or bedroom, putting up a fence, putting in new plumbing or wiring, installing a new roof, or paving your driveway are improvements, and their costs are added to your basis in your property. Assessments for local improvements. Assessments for improvements such as streets and sidewalks, which tend to increase the value of the property assessed, must be added to the basis of the property and not deducted as taxes. For example, if your city puts in a paved sidewalk along the street in front of your home and assesses you and the other affected landowners for the cost of the sidewalk, you must add the assessment to the basis of your property. However, you can deduct as taxes assessments you pay for maintenance or repair or meeting interest charges on the improvements. Decreases to Basis You must decrease the basis of your property by any items that represent a return of capital, such as the receipt of nontaxable dividends. Casualties and thefts. If you have a casualty or theft loss, you must decrease the basis of your property by the amount of any insurance or other reimbursement you receive and by any deductible loss not covered by insurance. However, increase your basis for amounts you spend after a casualty to restore the damaged property. For more information, see Chapter 26. Easements. The amount you receive for granting an easement is usually considered to be from the sale of an interest in your real property. It reduces the basis of the affected part of the property. If the amount received is more than the basis of the part of the property affected by the easement, your basis is reduced to zero and the excess is a recognized gain. Residential energy credit. The residential energy credit is no longer available. However, if you were allowed the credit, you must decrease the basis of your home by the amount of the credit if you added the cost of the energy items to the basis of your home. Section 179 deduction. If you elect to take the section 179 deduction for any part of the cost of property, you must decrease the basis of the property by the amount of the section 179 deduction. Depreciation. You must decrease the basis of your property by the amount of depreciation that you could have deducted on your tax returns under the method of depreciation you selected. If you deducted more depreciation than you should have, you must decrease your basis by the amount you should have deducted, plus the part of the excess deducted that resulted in a decrease in your tax liability for any year. However, if you deducted less depreciation than you could have, decrease your basis by the amount that you could have deducted. Usually, you figure the amount of depreciation you could have deducted by using the accelerated cost recovery system (ACRS) or the modified accelerated cost recovery system (MACRS) for recovery property and the straight line method for other property. Adjusted Basis Example You owned a duplex used as rental property that cost you $40,000. The $40,000 cost was allocated $35,000 for the building and $5,000 for the land. You added an improvement to the duplex that cost $10,000. On February 1, 1991, the duplex was damaged by fire. Up to that time you had been allowed depreciation of $23,000. You sold the salvage for $1,300 and collected $19,700 from your insurance company. You deducted a casualty loss of $1,000 on your 1991 income tax return. You spent $19,000 of the insurance proceeds for restoration of the duplex, which was completed in 1992. The adjusted basis of the duplex, after the restoration, is figured as follows: Original cost of duplex ....................... $35,000 Addition to duplex ............................ 10,000 __________ Total cost of duplex .......................... $45,000 Minus: Depreciation ........................... 23,000 __________ Adjusted basis before casualty ................ $22,000 Minus: Casualty loss ................ $1,000 Insurance proceeds ........... 19,700 Salvage proceeds ............. 1,300 22,000 __________ __________ Adjusted basis after casualty ................. $ 0 Add: Cost of restoring duplex ................. 19,000 Adjusted basis after restoration .............. $19,000 ========== Your basis in the land is its original cost of $5,000. Other Basis There are many times when you cannot use cost as a basis. In these cases the fair market value or the adjusted basis of certain property may be important. Fair market value. Fair market value is the price at which the property would change hands between a buyer and a seller, neither being required to buy or sell, and both having reasonable knowledge of all necessary facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property. Property received for services. If you receive property for your services, you must include the property's fair market value in income. The amount you include in income becomes your basis. Restricted property. If you receive property for your services and the property is subject to certain restrictions, your basis in the property is its fair market value when you can transfer it or when it is not subject to a substantial risk of forfeiture. For more information, see Restricted Property Received for Services, in Publication 525, Taxable and Nontaxable Income. Bargain purchases. If your employer lets you purchase goods or other property at less than fair market value, you must include the difference between the purchase price and the fair market value of the property in your income. However, if this difference represents a qualified employee discount, you do not include the difference in income. See Qualified Employee Discount in Chapter 6. Your basis in the property is its fair market value, that is, your purchase price plus the amount (if any) you include in your income. Taxable exchanges. A taxable exchange is one in which the gain is taxable or the loss is deductible. If you receive property in exchange for other property in a taxable exchange, the basis of the property you receive is usually its fair market value at the time of the exchange. Involuntary Exchanges If you acquire property as a result of an involuntary exchange, such as a casualty, theft, or condemnation, the basis of the replacement property you acquire may be figured using the basis of the property exchanged. Similar or related property. If you receive property that is similar or related in service or use to the property exchanged, the basis of the new property is the same as the basis of the old property, decreased by any loss recognized on the exchange and money received that was not spent on similar property and increased by any gain recognized on the exchange and any added cost of getting the new property. Not similar or related property. If you receive money or other property that is not similar or related in service or use to the old property, and you buy new property that is similar or related in service or use to the old property, the basis of the new property is the cost of the new property, decreased by the amount of gain that is not recognized on the exchange. Example. Your property was condemned by the state. The property had an adjusted basis of $26,000, and the state paid you $31,000 for it. You realized a gain of $5,000 ($31,000 - $26,000). You bought new property that is similar in use to the old property for $29,000, and you recognize a gain of $2,000 ($31,000 - $29,000), the unspent part of the payment from the state. The basis of the new property is figured as follows: Cost of new property .......................... $29,000 Minus: Gain not recognized .................... 3,000 __________ Basis of new property ..................... $26,000 Allocating the basis. You must allocate the basis among the parts of the new property you acquire as a result of an involuntary exchange. This allocation usually is based on the ratios of the fair market value of each part of the new property to the total fair market value of the whole new property. If you buy more than one piece of replacement property, allocate your basis among the properties based on their respective costs. If, in the previous example, the state had condemned unimproved real property, and the new property you bought was improved real property with both land and buildings, you would allocate the basis of the new property, $26,000, between land and buildings based on their fair market values. Nontaxable Exchanges A nontaxable exchange is an exchange in which any gain is not taxed and any loss cannot be deducted. In a nontaxable exchange, business or investment property is exchanged solely for like-kind or like-class property, stock is exchanged solely for stock of the same corporation, or property is exchanged for securities of a controlled corporation. Partially nontaxable exchange. A partially nontaxable exchange is an exchange in which you receive unlike property or money in addition to like-kind or like-class property. Basis of property. The basis of property you receive in a nontaxable or partially nontaxable exchange is usually the same as the basis of the property exchanged decreased by any money you received and any loss recognized on the exchange; and then increased by any additional costs incurred, and any gain recognized on the exchange. See Nontaxable Trades in Chapter 15. The basis must be allocated among the properties, other than money, that you received in the exchange. In making this allocation, the basis of the unlike property is its fair market value on the date of exchange. The remainder is the basis of the like-kind or like-class property. Example. You trade in an old truck, which has an adjusted basis of $1,700, for a new one costing $6,800. The dealer allows you $2,000 on the old truck, and you pay $4,800 in cash. This is a nontaxable exchange, and the basis of the new truck is $6,500, that is, the adjusted basis of the old one, $1,700, increased by the additional cost, $4,800. If you sell your old truck to a third party for $2,000 and then buy the new one from the dealer, you have a taxable gain on the sale, and the basis of the new truck is the price you pay the dealer for it. Trade-in or sale and purchase. You cannot increase the basis of property for depreciation by selling your old property outright to a dealer and then buying the new property from the same dealer, if the sale and purchase are actually a single transaction. If the sale to the dealer of your old property and your purchase from that dealer of the new property are dependent on each other, you are considered to have traded in your old property. The transaction is treated as an exchange no matter how it is carried out. Example. You are a salesperson and use one of your cars 100% for business. You have used this car in your sales activities for 2 years and have depreciated it. Your adjusted basis in the car is $2,600, and its market value is $3,100. You are interested in a new car with a listed retail price of $8,695, which usually sells for $8,000. If you trade your old car for the new one and pay the dealer $4,900, your basis for depreciation for the new car would be $7,500 ($4,900 cash plus $2,600 basis of your old car). However, you want a higher basis for depreciating the new car, so you agree to pay the dealer $8,000 cash for the new car if he will pay you $3,100 for your old car. Since the sale and purchase are dependent on each other, you are treated as if you had exchanged your old car for the new one. Your basis for depreciating the new car is $7,500, which is the same as it would be if you had traded the old car. For information about the trade of a car used partly for business, see Publication 917, Business Use of a Car. Property Received as a Gift To figure the basis of property you receive as a gift, you must know its adjusted basis to the donor just before it was given to you, its fair market value (FMV) at the time it was given to you, and the amount of gift tax paid on it. FMV less than donor's adjusted basis. If the FMV of the property was less than the donor's adjusted basis, your basis for depreciation, depletion, and amortization, and for gain on its sale or other disposition, is the same as the donor's adjusted basis. Your basis for loss on its sale or other disposition is its FMV at the time you received the gift. Example. You received an acre of land as a gift. At the time of the gift, the acre had a FMV of $8,000. The donor's adjusted basis was $10,000. If you later sell the property for $12,000, you have a $2,000 gain because you use the donor's adjusted basis ($10,000) at the time of the gift as your basis to report a gain. If, however, you sell the property for $7,000, you have a loss of $1,000 because you use the FMV ($8,000) at the time of the gift to report a loss. If the sales price is between $8,000 and $10,000, you have neither a gain nor a loss. For instance, if the sales price was $9,000 and you computed for a gain using the donor's adjusted basis ($10,000), you would show a loss of $1,000. If you then computed for a loss using the FMV ($8,000), you would show a gain of $1,000. FMV more than donor's adjusted basis. If the FMV of the property was equal to or greater than the donor's adjusted basis, your basis is the same as the donor's adjusted basis at the time you received the gift. Your basis is increased by all or part of the gift tax paid, depending on the date of the gift. Gift received before 1977. If you received a gift before 1977, your basis in the gift (the donor's adjusted basis) is increased by the total gift tax paid on it, but not above the FMV of the gift when it was given to you. Example 1. You were given a house in 1976. At that time it had a FMV of $21,000, and the donor's adjusted basis was $20,000. The donor paid a gift tax of $500. Your basis for gain or loss and for depreciation is $20,500, the donor's adjusted basis plus the gift tax paid. Example 2. If, in Example 1, the gift tax paid had been $1,500, your basis would be $21,000. This is the donor's adjusted basis plus the gift tax paid, limited to the FMV of the house at the time you received the gift. Gift received after 1976. If you received a gift after 1976, your basis in the gift (the donor's adjusted basis) is increased by the part of the gift tax paid that is due to the net increase in value of the gift. This part is figured by multiplying the gift tax paid on the gift by a fraction. The numerator (top part) of the fraction is the net increase in value of the gift, and the denominator (bottom part) is the amount of the gift. The net increase in value of the gift is the FMV of the gift minus the donor's adjusted basis. Example. In 1992 you received a gift of property from your mother. At that time the property had a FMV of $50,000, and her adjusted basis was $20,000. She paid a gift tax of $9,000 on the property. For figuring depreciation, depletion, amortization, and gain or loss, your basis is $25,400, figured as follows: Fair market value ............................. $50,000 Minus: Adjusted basis ......................... 20,000 __________ Net increase in value ........................ $30,000 ========== Gift tax paid ................................. $9,000 Multiplied by ($30,000 ÷ $50,000) ............. .60 __________ Gift tax due to net increase in value ......... $5,400 Adjusted basis of property to your mother ..... 20,000 __________ Your basis in the property .................... $25,400 ========== Property Transferred From a Spouse The basis of property transferred to you or transferred in trust for your benefit by your spouse, or by your former spouse if the transfer is incident to divorce, is the same as the transferor's adjusted basis of the property. However, your basis is adjusted for any gain recognized by the transferor on a transfer of property in trust in which the sum of the liabilities assumed, plus the liabilities to which the property is subject, is more than the adjusted basis of the property transferred. If the property transferred is a Series E or EE United States savings bond, the transferor must include in income the interest accrued to the date of transfer. The transferee's basis in the bond immediately after the transfer is equal to the transferor's adjusted basis in the bond increased by the interest income includible in the transferor's income. The transferor must supply you with records necessary to determine the adjusted basis and holding period of the property as of the date of the transfer. For more information regarding the transfer of property between spouses, see Chapter 15. Inherited Property Your basis in property you inherit is usually its fair market value (FMV) at the date of the decedent's death. If a federal estate tax return has to be filed, your basis in property you inherit can be its FMV at the alternate valuation date if the estate qualifies and elects to use alternate valuation. If a federal estate tax return does not have to be filed, your basis in the property is its appraised value at the date of death for state inheritance or transmission taxes. Your basis in inherited property may also be figured under the special farm or closely held business real property valuation method, if chosen for estate tax purposes. See Publication 448, Federal Estate and Gift Taxes, for information on valuation methods for estate tax purposes. For more information about the basis of inherited property, such as property held by a surviving tenant and qualified joint interest in property held by a husband and wife, see Inherited Property in Publication 551, Basis of Assets. Property Changed to Business or Rental Use When you hold property for personal use and change it to business use or use it to produce rent, such as renting out your former home, you must figure the basis for depreciation. Basis for depreciation. The basis for depreciation equals the lesser of: 1) The FMV (defined earlier under Other Basis) of the property on the date of the change, or 2) Your adjusted basis on the date of the change - that is, your original cost or other basis of the property, plus the cost of permanent improvements or additions since you acquired it, minus deductions for any casualty losses claimed on earlier years' income tax returns and other decreases to basis. Example. Several years ago you built your home for $60,000 on a lot that cost you $10,000. Before changing the property to rental use last year, you added $20,000 of permanent improvements to the house and claimed a $2,000 deduction for a casualty loss to the house. Because land is not depreciable, you can include only the cost of the house when figuring the basis for depreciation. Your adjusted basis in the house at the time of the change in use is $78,000 ($60,000 + $20,000 - $2,000). On the date of the change in use, your property has a FMV of $80,000, of which $15,000 is for the land and $65,000 is for the house. The basis for depreciation on the house is the FMV at the date of the change ($65,000) because it is less than your adjusted basis ($78,000). Sale of property. If you later sell or dispose of the property, the basis of the property to be used will depend on whether you are figuring gain or loss. Gain. The basis for gain is your adjusted basis when you sell the property - that is, your original cost or other basis, plus the cost of any permanent improvements or additions, less depreciation allowed or allowable, deductions for casualty losses claimed on prior years' returns, and other decreases to basis, such as amounts received for easements or rights-of-way. Loss. The basis for loss is figured using the smaller of your adjusted basis or the FMV of the property at the time of the change to business or rental use. Increase this amount by the cost of improvements and additions you made after the change, and reduce it by the depreciation, allowed or allowable, and casualty loss deductions you claimed after the change. Example. You sell your house, which you had changed to rental property after using it as your home. When you changed it to rental use, it had a FMV of $33,000 and an adjusted basis of $35,000. In your case the original cost of your house and the adjusted basis were the same, as there were no increases or decreases to basis since its purchase. You claimed $3,000 depreciation, figured under the straight line method, while renting it. Your adjusted basis at the time of the sale, for figuring gain, is $32,000 ($35,000 - $3,000). This was your original cost less depreciation. Your adjusted basis at the time of the sale, for figuring loss, is $30,000 ($33,000 - $3,000). This was the FMV, when you changed it to rental use, less depreciation. In this example, FMV must be used because it was smaller than the adjusted basis at the time you changed the house to rental use. If the sales price is between $30,000 and $32,000, you have neither a gain nor a loss on the sale. Stocks and Bonds The basis of stocks or bonds you own generally is the purchase price plus the costs of purchase such as commissions and recording or transfer fees. If you acquired stocks or bonds other than by purchase, your basis is usually determined by fair market value or the donor's adjusted basis, as previously discussed. The basis must be adjusted for certain events that occur after purchase. For example, if you receive additional stock from nontaxable stock dividends or stock splits, you must reduce the basis of your original stock. You must also reduce your basis when you receive nontaxable distributions because these are a return of capital. Example. In 1990, you bought 100 shares of XYZ stock for $1,000 or $10 a share. In 1991, you bought 100 shares of XYZ stock for $1,600 or $16 a share. In 1992, XYZ declared a 2-for-1 stock split. You now have 200 shares of stock with a basis of $5 a share and 200 shares with a basis of $8 a share. Other basis. There are other ways to determine the basis of stocks or bonds depending on how you acquired them. Some ways in which you can acquire stock are by automatic investment programs, dividend reinvestment plans, and stock rights. For detailed information, see Publication 550, Investment Income and Expenses. Identifying shares. If you buy and sell securities at different times in varying quantities and you cannot definitely identify the securities you sell, the basis of those sold is figured under the first-in first-out method- that is, the first securities you acquired are the first sold. Identification. You make an adequate identification if you deliver to your broker or agent certificates for securities that you purchased on a certain date or for a specific price. If you left the security certificates with your broker or other agent, an adequate identification is made if you: 1) Tell your broker the particular security to be sold or transferred at the time of the sale or transfer, and 2) Receive a written confirmation of this from your broker or other agent within a reasonable time. If you bought securities in different lots at different times and you hold a single certificate for these securities, you make an adequate identification if you: 1) Tell your broker the particular security to be sold or transferred when you deliver the certificate to your broker, and 2) Receive a written confirmation of this from your broker or other agent within a reasonable time. Mutual fund shares. You can choose to use the average basis of shares you own in a regulated investment company (mutual fund) if you acquired the shares at different times and prices, and if you left the shares on deposit in an account kept by a custodian or agent. For more information, see Publication 564, Mutual Fund Distributions. Premiums on bonds. If you buy a taxable bond at a premium and choose to amortize the premium paid, you must reduce the basis of the bond by the amount of the amortized premium. See Bond Premium Amortization in Chapter 3 of Publication 550 for more information. Although you cannot take a deduction for the premium on tax-exempt bonds, you must amortize the premium and decrease your basis in the bonds by the amount of the amortizable bond premium. Original issue discount (OID) on debt instruments. You must increase your basis in an OID debt instrument by the amount of OID that you included in income for that instrument. See Original Issue Discount in Chapter 8. Tax-exempt bonds. OID on tax-exempt bonds is not taxable. However, there are special rules for determining basis on tax-exempt OID bonds issued after September 3, 1982, and acquired after March 1, 1984. See Chapter 1 of Publication 550.