Tax basis of business asset is the amount the tax code says you have invested in an asset—which may be quite a different figure from what you think. Your tax basis in an asset determines how much you can deduct each year for it. Tax basis is also used to determine your taxable gain or loss when you sell or dispose of the asset. IRS Publication 551, Basis of Assets, is a 12-page explanation of the law on basis that goes beyond the summary that outlined in this post.
Generally, the beginning tax basis of an asset is what you paid for it [IRC 1012]. So, if Stephen Brown pays $3,000 for a dry cleaning machine for his store, Clean World, that’s his beginning basis. Related costs, such as $200 for freight to get it to Clean World and $150 for installation, are added to the beginning basis, making it $3,350.
Basis also includes state and local taxes [meaning that any use or sales-type taxes you pay are deductible along with the item itself]. These taxes become part of the basis of the asset, meaning that sales or use tax cannot be completely written off in the year the item was bought [unless it qualifies for Section 179 treatment]. For instance, an 8% state sales tax on a truck bought for $10,000 [$800] must be added to its basis [$10,800] and written off over the period the truck is depreciated, usually six years.
Tax Basis of Assets You Receive as a Gift
If you receive something as a gift, you take the same tax basis as the person who gave it to you. This is called a “transferred basis” [IRC 1015].
Example: Christian’s father, David, gives him a building worth $60,000. David’s tax basis in the property was $15,000; Christian has a transferred basis the same as his father’s: $15,000. So if Christian immediately sells the building for its fair market value of $60,000, he will owe tax on a $45,000 gain [the sales price, $60,000, less his tax basis, $15,000].
Tax Basis of Assets You Receive for Services
If you receive something in exchange for your services, your basis is its fair market value [IRC 7701]. The value of the asset is taxable income. If the asset is then used in your business, it may be deducted under the depreciation rules.
Example: In 2007, Mark refinished four antique chests for Kevin; in exchange, he received one of them. Because it could be sold for $250, its fair market value was $250, which became Mark’s tax basis in the chest. He should report $250 as income on his 2007 tax return. When Mark sells the chest for $350 two years later, he has a further taxable gain of $100 [less any costs of making the sale, such as a newspaper classified ad].
Tax Basis of Assets You Inherit
If you inherit something and put it to use in your business, the tax basis of the item is its fair market value on the date of death of the person who left it to you [IRC 1014]. That usually means you get a big tax break when you sell. This is because your taxable profit is based on the date-of-death value, which could be considerably more than the former owner paid for it. This is referred to as a step-up basis.
Example: Ruth dies and leaves a warehouse to her son, Brad. She bought the property in 1970 for $50,000, and it was worth $200,000 on the real estate market when Ruth died. When Brad inherits the warehouse, his basis in it is $200,000. Brad, who has an insurance agency, can’t use the warehouse, but needs a small office building for his business. Brad sells the warehouse for $200,000. He has no taxable gain or loss, because $200,000 was his tax basis. Brad can then buy a new building with the proceeds and begin taking depreciation deductions as soon as he starts using it for his insurance business.
Tax Basis of Assets You Receive in Exchange for Other Assets
If you trade an asset, the basis of the newly acquired asset is usually the same as the property you traded. This is called substituted basis.
Example: Stephanie, a cabinetmaker, trades a table saw with a tax basis of $250 to Marco for his industrial shop vac. Her basis in the shop vac is $250.
The tax code doesn’t allow substituted basis for all exchanges. To be nontaxable, the trade must be for like kind property. For instance, if you trade away real estate, you must receive real estate in exchange. And if you trade tangible property [such as Stephanie’s table saw, above], you can’t get intangible property, such as a copyright, in return. If you trade different types of things, the tax code says this is a sale of one item [normally resulting in a taxable profit], followed by the purchase of another item, and not a tax-free exchange of like kind property.
Tax Basis of Assets Exchanged for Assets and Money
If you trade something and throw in money to boot, your basis in the newly acquired property equals the basis of the asset you exchanged plus the amount you paid in cash—called “boot“ in tax lingo.
Example: Ray trades his old Ford pickup [tax basis of $3,000] and $10,000 cash [the boot] to Truck City for a new Chevy. Kevin’s basis in the new truck is $13,000.
Conversely, if you receive an asset plus money, your basis in the item is reduced by the amount of the cash.
Example: Kenneth trades his Hummer with a basis of $50,000 for a used Dodge pickup and $40,000 in cash. Ken’s basis in the Dodge is $10,000.
Tax Basis of Assets You Convert to Business Use
When you convert personal, non-business assets to business use, you must determine their basis at the time you make the switch. The tax basis of converted property is the lesser of:
- the fair market value of the asset on the date you convert it to business use; or
- your adjusted basis in that property [IRC 167].
Example-1: Joshua bought a $2,500 computer a year ago for fun and games, but now starts using it in his snowboard shop. The tax basis of the computer is the lesser of Joshua’s cost or its current fair market value. Joshua finds its fair market value is now $1,000, which becomes its tax basis as a business asset.
Example-2: Christina pays $60,000 to have a home built on a lot valued at $10,000. She lives in the home five years and spends $20,000 for improvements. One year Christina claims a $2,000 tax deduction for a casualty loss when a runaway car hits her living room. Over time, Christina’s house comes to have a fair market value of $125,000. Christina moves out and converts the house into a health food store. The tax basis of the converted building is computed as follows:
$60,000 cost to build home
+ 20,000 improvements over the years
– 2,000 deduction taken for casualty loss
= $78,000 tax basis at time of conversion
[Note: The $10,000 cost of the land is not part of the basis of the building; as land, it is never depreciable under the tax code].
Christina must use $78,000 as her tax basis because it is less than the fair market value of
$125,000, according to the tax rule discussed above [IRC 167].
Example-3: Going back to Christina’s situation, if the building’s fair market value had decreased to $50,000 at the time of the conversion, Christina’s basis would have decreased to $50,000 as well. That’s because she must use the fair market value as her basis whenever it is lower than her adjusted basis [IRC 167, Reg. 1.167].