It’s my annual Taxes from A to Z series! This time, it’s Tax Cuts and Jobs Act (TCJA) style. If you’re wondering whether you can claim house office expenses or whether to deduct a capital loss under the new law, you won’t want to miss a single letter.
U is for Unadjusted Basis.
Basis is, at its most simple, the cost that you pay for assets. The actual cost is sometimes referred to as unadjusted basis (or sometimes, 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 unadjusted basis.
If you make a capital improvement (a major change that adds permanent value) to your house, that increases your basis. The result is sometimes called the adjusted basis (clever, right?).
So, at its most simple: Adjusted basis = cost (unadjusted basis) + adjustments.
Building on our example, if your capital 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 unadjusted basis. If you roll dividends or other income into an account to purchase more stock, such as a DRIP (more on DRIPs here), the income is reported on your tax return, and it adds to your basis. Basis can also be affected by corporate transactions like splits, mergers or spin-offs.
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; you’ll pay capital gains (or report capital losses) using that amount. So in my house example, if I sold the house for $200,000, the taxable gain would be $35,000, or $200,000 – $165,000.
Sometimes, basis is adjusted as a matter of law. For example, there’s 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.
Continuing our example, if the house was worth $200,000 on the date of death, the new basis would be $200,000; 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 there’s minimal 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. Continuing our example, if the house is given away during lifetime, even if the house was worth $200,000 when the gift is made, the basis for the new owner is $165,000 (the original owner’s basis).
Basis doesn’t just matter to individual taxpayers: corporate and pass-through taxpayers care about basis, too, not only for capital gains, but for deductions. Remember the pass-through deduction under the TCJA (good ol’ Section 199A)? If your income is above the threshold amount, the deduction may be subject to the wage and capital limit. To figure the limit, you’ll need to know the unadjusted basis of your qualified property (you can see the formula here).
Keeping track of basis can be time-consuming and difficult, and until a few years ago, it was entirely the responsibility of the taxpayer. In 2011, the Emergency Economic Stabilization Act of 2008 (EESA), the law changed: now, 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 the unadjusted 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.
That doesn’t mean you have a pass to be sloppy. It’s still important to keep excellent records of your transactions, and double-check basis reporting on forms 1099-B. And remember that tracking the basis for assets not covered by EESA, like real property, remains your responsibility.
For more Taxes From A To ZTM 2019, check out the rest of the series: