Why Tax Basis Is So Important

Why Tax Basis Is So Important

For tax purposes, the term “basis” refers to the original monetary value that is used to measure a gain or loss. For instance, if you purchase shares of a stock for $1,000, your basis in that stock is $1,000; if you then sell those shares for $3,000, the gain is calculated based on the difference between the sales price and the basis: $3,000 – $1,000 = $2,000. This is a simplified example, of course—under actual circumstances, purchase and sale costs are added to the basis of the stock—but it gives an introduction to the concept of tax basis.

The basis of an asset is very important because it is used to calculate deductions for depreciation, casualties, and depletion, as well as gains or losses on the disposition of that asset.

The basis is not always equal to the original purchase cost. It is determined in a different way for purchases, gifts, and inheritances. In addition, the basis is not a fixed value, as it can increase as a result of improvements or decrease as a result of business depreciation or casualty losses. This article explores how the basis is determined in various circumstances.

Cost Basis – The cost basis (or unadjusted basis) is the amount originally paid for an item before any improvements and before any business depreciation, expensing, or adjustments as a result of a casualty loss.

Adjusted Basis – The adjusted basis starts with the original cost basis (or gift or inherited basis), then incorporates the following adjustments:

  • increases for any improvements (not including repairs),
  • reductions for any claimed business depreciation or expensing deductions, and
  • reductions for any claimed personal or business casualty-loss deductions.

Example: You purchased a home for $250,000, which is the cost basis. You added a room for $50,000 and a solar electric system for $25,000, then replaced the old windows with energy-efficient double-paned windows at a cost of $36,000. The adjusted basis is thus $250,000 + $50,000 + $25,000 + $36,000 = $361,000. Your payments for repairs and repainting, however, are maintenance expenses; they are not tax deductible and do not add to the basis.

Example: As the owner of a welding company, you purchased a portable trailer-mounted welder and generator for $6,000. After owning it for 3 years, you then decide to sell it and buy a larger one. During this period, you used it in your business and deducted $3,376 in related deprecation on your tax returns. Thus, the adjusted basis of the welder is $6,000 – $3,376 = $2,624.

Keeping records regarding improvements is extremely important, but this task is sometimes overlooked, especially for home improvements. Generally, you need to keep the records of all improvements for 3 years (and perhaps longer, depending on your state’s rules) after you have filed the return on which you report the disposition of the asset.

Gift Basis – If you receive a gift, you assume the doner’s adjusted basis for that asset; in effect, the doner transfers any taxable gain from the sale of the asset to you.

Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. However, your mother originally purchased the shares for $5,000. You assume your mother’s basis of $5,000; if you then immediately sell the shares, your taxable gain is $15,000 – $5,000 = $10,000.

There is one significant catch: If the fair market value (FMV) of the gift is less than the doner’s adjusted basis, and if you then sell it for a loss, your basis for determining the loss is the gift’s FMV on the date of the gift.

Example: Again, say that your mother purchased stock shares for $5,000. However, this time, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. In this case, your tax-deductible loss is only $1,000 (the sales price of $3,000 minus the $4,000 FMV on the date of the gift), not $2,000 ($3,000 minus your mother’s $5,000 basis).

Inherited Basis – Generally, a beneficiary who inherits an asset uses its FMV on the date when the owner died as the tax basis. This is because the tax on the decedent’s estate is based on the FMV of the decedent’s assets at the time of death. Normally, inherited assets receive a step up (increased) in basis. However, if an asset’s FMV is less than the decedent’s basis, then the beneficiary’s basis is stepped down (reduced).

Example: You inherit your uncle’s home after he dies. Your uncle’s adjusted basis in the home was $50,000, but he purchased the home 25 years ago, and its FMV is now $400,000. Your basis in the home is equal to its FMV: $400,000.

Example: You inherit your uncle’s car after he dies. Your uncle’s adjusted basis in the car was $50,000, but he purchased the car 5 years ago, and its FMV is now $20,000. Your basis in the car is equal to its FMV: $20,000.

An inherited asset’s FMV is very important because it is used when determining the gain or loss after the sale of that asset. If an estate’s executor is unable to provide FMV information, the beneficiary should obtain the necessary appraisals. Generally, if you sell an inherited item in an arm’s-length transaction within a short time, the sales price can be used as the FMV. A simple example of not at arm’s length is the sale of a home from parents to children. The parents might wish to sell the property to their children at a price below market value, but such a transaction might later be classified by a court as a gift rather than a bona fide sale, which could have tax and other legal consequences.

For vehicles, online valuation tools such as Kelly Blue Book can be used to determine FMV. The value of publicly traded stocks can similarly be determined using Website tools. On the other hand, for real estate and businesses, valuations generally require the use of certified appraisal services.

The foregoing is only a general overview of how basis applies to taxes. If you have any questions, please call this office for help.


Isler Northwest LLC is a firm of certified public accountants and business advisors based in Portland, Oregon. Our local, regional, and global resources, our expertise, and our emphasis on innovative solutions and continuity create value for our clients. Our service goals at Isler Northwest is to earn our clients trust as their primary business and financial advisors.

Isler Northwest

(503) 224-5321

1300 SW 5th Avenue
Suite 2900
Portland, Oregon 97201

Tax Treatment of a Room Rental

Tax Treatment of a Room Rental

With the shortage of affordable housing these days, many homeowners are renting out rooms in their homes, providing themselves with some additional cash. Questions that are often raised in regard to room rentals include: Is the income taxable? If so, how is it reported? What deductions are allowed? Can a loss be claimed? Answers to these questions follow.

If a taxpayer rents rooms or other space in a home and the rented portion does not have facilities (a bathroom and a kitchen) that would make it a dwelling unit on its own, the taxpayer and the renter may be considered to be occupying one dwelling unit. Thus, the “landlord” is mixing personal expenses with business expenses, a situation in which the tax code does not permit a loss.

As a result, the income and expenses are treated under the same rules as vacation home rentals and are reported on Schedule E, with prorated expenses deductible against the rental income in a specific order and no loss being allowed.

The deductions are claimed in the following order:

  1. First, mortgage interest and taxes.
  2. Next, operating expenses (examples: advertising, repairs, utilities, maintenance, insurance).
  3. Finally, depreciation.

If the result is a loss, the expenses are only allowed until the income is reduced to zero.

But some unusable expenses may be carried over to the next year, where again they and the next year’s expenses will be limited to the next year’s rental income.

Tax Treatment of a Room Rental
Because the expenses are taken in a specific order, home mortgage interest and property taxes paid for the home (which, for many taxpayers, would be deductible anyway) are first deducted from the rental income. Next come the operating expenses, of which only $1,300 of $1,417 is deductible in this example because that amount reduces the rental income to zero. Thus, $117 of the operating expenses and the depreciation are not deductible.

Any reasonable method for dividing the expenses may be used. The two most common methods for allocating expenses, such as mortgage interest and heat for the entire house, are based on the number of rooms in and square footage of the home.

If you have questions related to renting a room or a vacation home, or about short-term rentals of your home, please give this office a call.

Some Electric Vehicle Credits Are Phasing Out!

Some Electric Vehicle Credits Are Phasing Out!

The IRS recently announced that the tax credit for purchasing the popular Tesla is being phased out and that the credit will drop to $3,750 after December 31, 2018, and will drop again to $1,875 after June 30, 2019. Then, the credit will no longer be available for a Tesla after December 31, 2019. But Tesla is not the only plug-in electric vehicle eligible for the credit, and a full list of vehicles qualifying for credit is available on the IRS’s website.

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Filing a 1099-MISC May Now Apply to Landlords. Are You Collecting the Needed W-9s?

Filing a 1099-MISC May Now Apply to Landlords. Are You Collecting the Needed W-9s?

If you use independent contractors to perform services for your business or your rental that is a trade or business, for each individual whom you pay $600 or more for the year, you are required to issue the service provider and the IRS a Form 1099-MISC after the end of the year, to avoid losing the deduction for their labor and expenses. (This requirement generally does not apply to payments made to a corporation. However, the exception does not extend to payments made for attorney fees and for certain payments for medical or health care services.)

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IRS Giving a Break to Some Taxpayers Who Under-prepaid Their 2018 Taxes

IRS Giving a Break to Some Taxpayers Who Under-prepaid Their 2018 Taxes

Taxpayers are required to pre-pay their taxes for any tax year through payroll withholding, estimated tax payments or a combination of the two. Employees and retirees generally accomplish this through withholding, and self-employed individuals and those with investment income by paying quarterly estimated payments.

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Short-Term Rental, Special Treatment

Short-Term Rental, Special Treatment

With the advent of online sites such as Airbnb, VRBO, and HomeAway, many individuals have taken to renting out their first or second home through these online rental sites, which match property owners with prospective renters. If you are doing that or are planning to do so, there some special tax rules you need to know.

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Tax Time Is Around the Corner

Tax Time Is Around the Corner! Are You Ready?

Tax time is just around the corner, and if you are like most taxpayers, you are finding yourself with the ominous chore of pulling together the records for your tax appointment.

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A Mid-Year Tax Checkup May Be Appropriate

Do I Qualify for an IRS Offer in Compromise?

If you’re facing outstanding tax debt that you cannot pay, you may want to consider looking into an Offer in Compromise from the IRS. Specifically, an Offer in Compromise is an option offered from the IRS to qualifying individuals that allows them to settle tax debt for less than what they actually owe.

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Will Gifts Now Using the Temporarily Increased Gift-Estate Exclusion Harm Estates after 2025?

Will Gifts Now Using the Temporarily Increased Gift-Estate Exclusion Harm Estates after 2025?

Individuals with large estates generally want to gift portions of their estate to beneficiaries while they are still living, to avoid or lessen the estate tax when they pass away. That can be done through annual gifts (up to the inflation-adjusted annual limit for each gift recipient each year – $15,000 for 2019) and/or by utilizing the unified gift-estate exclusion for gifts in excess of the annual exclusion amount. The tax reform virtually doubled the unified gift-estate exclusion for years 2018 through 2025, after which – unless further extended by Congress – it will return to its inflation-adjusted former amount. This has caused concerns related to what the tax consequences will be for post-2025 estates if the decedent, while alive, had made gifts during the 2018-through-2025 period utilizing the higher unified gift-estate exclusion. Would that cause a claw back due to the reduced exclusion?

The Treasury Department has proposed taxpayer-friendly regulations to implement changes made by the tax reform, the 2017 Tax Cuts and Jobs Act (TCJA). As a result, individuals planning to make large gifts between 2018 and 2025 can do so without concern that they will lose the tax benefit of the higher exclusion level for those gifts once the exclusion decreases after 2025.

In general, gift and estate taxes are calculated using a unified rate schedule on taxable transfers of money, property, and other assets. Any tax due is determined after applying a credit based on an applicable exclusion amount.

The applicable exclusion amount is the sum of the basic exclusion amount established in the statute plus other elements (if applicable) described in the proposed regulations. The credit is first used during life to offset gift tax, and any remaining credit is available to reduce or eliminate estate tax.

The TCJA temporarily increased the basic exclusion amount from $5 million to $10 million for tax years 2018 through 2025, with both dollar amounts adjusted for inflation. For 2018, the inflation-adjusted basic exclusion amount is $11.18 million; for 2019, it is $11.4 million. In 2026, the basic exclusion amount will revert to the 2017 level of $5 million, adjusted for inflation.

To address concerns that an estate tax could apply to gifts exempt from gift tax through the increased basic exclusion amount, the proposed regulations provide a special rule that allows the estate to compute its estate tax credit using the higher of the basic exclusion amount applicable to gifts made during life or the basic exclusion amount applicable on the date of death.

If you have any questions related to gifting and estate planning, please give this office a call.

 


Isler Northwest LLC is a firm of certified public accountants and business advisors based in Portland, Oregon. Our local, regional, and global resources, our expertise, and our emphasis on innovative solutions and continuity create value for our clients. Our service goals at Isler Northwest is to earn our clients trust as their primary business and financial advisors.

Isler Northwest

(503) 224-5321

1300 SW 5th Avenue
Suite 2900
Portland, Oregon 97201

The 1099-MISC Filing Date Is Just Around the Corner – Are You Ready

The 1099-MISC Filing Date Is Just Around the Corner – Are You Ready?

If  you engage the services of an individual (independent contractor) in your business, other than one who meets the definition of an employee, and you pay him or her $600 or more for the calendar year, then you are required to issue that person a Form 1099-MISC to avoid penalties and the prospect of losing the deduction for his or her labor and expenses in an audit. Payments to independent contractors are referred to as non-employee compensation (NEC).

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