B is for Basis.
Basis is, at its most simple, the cost that you pay for assets. The actual cost is sometimes referred to as “cost basis” because you can make adjustments to basis over time.
When it comes to real property, your basis is your cost plus any significant improvements. So, for example, if you buy a house for $150,000, that’s your cost basis. If you make a capital improvement (a major change that adds permanent value) to your home, that increases your basis. If that improvement costs $15,000, then your basis is $165,000, or $150,000 (original purchase price) + $15,000.
Stocks and similar investments work the same way. The price that you pay for the stock is your cost basis. If you roll dividends or other income into an account to purchase more stock, that income is reported – and it adds to your basis. Additionally, basis can also be affected by a split, merger or spin off – check with your tax professional to assist with those fairly tricky concepts.
So, at its most simple:
Basis = cost + adjustments
To figure out a gain or a loss for income tax purposes, you take the price of the asset at disposition (in most cases, the sale price) and subtract the adjusted basis. That difference is your realized gain or loss – and that’s the number you pay capital gains tax on. So in my home example, if I sold the home for $200,000, the taxable gain would be $35,000, or $200,000 – $165,000.
The law allows a “step up” in basis for assets held at death: that means that basis is increased to the value of the asset as of the date of death. So in my example, if the home was worth $200,000 on the date of death, the new basis would be $200,000. In that event, the purchase price and the adjustments are no longer relevant. When the estate or heir subsequently sells the property, the gain is the selling price less the stepped up basis of $200,000. Assuming that the sale happens close to the date of death, there is generally no gain – or very little gain – for income tax purposes.
In contrast, “carry over” basis means that the original basis of the asset carries over from one owner to the next. This is what happens when you make a gift. In my home example, if the home is given away during lifetime, even if the home was worth $200,000 when the gift is made, the basis for the new owner is $165,000 (the former owner’s original basis).
As you can imagine, keeping track of basis for all of these assets can be time-consuming and difficult. And until a few years ago, it was completely the responsibility of the taxpayer. In 2011, the Emergency Economic Stabilization Act of 2008, the law changed: brokers are now required to track and report the basis of stocks, mutual funds, exchange traded funds (ETF), debt securities, options and private placements. Brokers must not only report basis but must also reflect adjustments for commissions and fees as well as other events that affect basis, such as a stock split. This happens on a form 1099-B, Proceeds from a Broker or Barter Exchange Transaction, or on a consolidated report.
The law was good news for most taxpayers because it made it easier to track basis on some financial assets. But it’s not a pass to get too comfortable: there’s still work to be done. Keep excellent records of buying and selling activities and double-check basis reporting on forms 1099-B. And remember that tracking the basis for certain assets, like real property, is all up to you as the taxpayer.
For more in the series, see:
Taxes from A to Z: A is for Affordable Care Act
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