Legal Definitions - basis

In U.S. tax law, basis refers to your original investment or value in an asset, such as real estate, stocks, or other property. It's a crucial figure used primarily to calculate your taxable profit or loss when you eventually sell, exchange, or otherwise dispose of that asset.

Initially, basis is often the purchase price of the asset, plus any additional costs incurred to acquire it and get it ready for use. These additional costs can include things like sales taxes, shipping fees, installation charges, or commissions. Over time, this initial basis can be adjusted upwards or downwards due to various events, creating what is known as an adjusted basis. For instance, significant improvements you make to a property would increase its basis, while certain tax deductions or casualty losses might decrease it.

Understanding your basis is essential because it directly impacts how much tax you might owe. If you sell an asset for more than its adjusted basis, the difference is generally considered a taxable gain. If you sell it for less, it might result in a deductible loss.

• Example 1: Selling a Rental Property

  Imagine Sarah buys a small apartment building for $300,000. She also pays $10,000 in closing costs, legal fees, and property transfer taxes. Her initial basis in the property is $310,000.

  Over five years, Sarah invests $50,000 in a new roof and updated kitchens, which increases her basis. However, she also claims $40,000 in depreciation deductions during her ownership, which decreases her basis. Her adjusted basis becomes $310,000 (initial) + $50,000 (improvements) - $40,000 (depreciation) = $320,000.

  If Sarah later sells the building for $400,000, her taxable gain would be $400,000 - $320,000 = $80,000.

  This example illustrates how the initial purchase price and related costs establish the basis, and how subsequent capital improvements increase it, while tax deductions like depreciation decrease it, leading to an adjusted basis used for calculating taxable gain upon sale.

• Example 2: Inherited Family Heirloom

  David inherits a valuable antique watch from his grandmother. She originally purchased it for $500 many decades ago. However, at the time of her death, the watch was appraised at its fair market value of $15,000.

  For tax purposes, David's basis in the inherited watch is generally its fair market value on the date of his grandmother's death, which is $15,000, not the $500 his grandmother paid. This is often referred to as a "step-up in basis."

  If David later sells the watch for $16,000, his taxable gain would be $16,000 - $15,000 = $1,000.

  This demonstrates that basis isn't always the original purchase price of the current owner. In cases of inheritance, the basis is often "stepped up" to the asset's fair market value at the time of the previous owner's death, which is crucial for determining the heir's future tax liability.

• Example 3: Investing in a Mutual Fund

  Emily invests $10,000 in a mutual fund. She also pays a $50 transaction fee to her broker. Her initial basis in the mutual fund shares is $10,050.

  Over several years, the mutual fund pays out dividends and capital gains distributions, which Emily chooses to automatically reinvest back into the fund, purchasing more shares. These reinvested amounts total $2,000.

  Her basis increases by the amount of these reinvested distributions. Her adjusted basis becomes $10,050 (initial) + $2,000 (reinvested distributions) = $12,050.

  If Emily later sells all her mutual fund shares for $14,000, her taxable gain would be $14,000 - $12,050 = $1,950.

  This example shows how the initial investment plus related fees establish basis, and how subsequent reinvestments of earnings (which are often taxable in the year they are received, even if reinvested) further increase the basis, reducing the capital gain when the investment is eventually sold.