Legal Definitions - substituted basis

In tax law, substituted basis refers to a situation where the cost basis of an asset (the value used to determine gain or loss when the asset is eventually sold) is not its original purchase price. Instead, this basis is derived either from the basis of a different asset or from the basis of the same asset in the hands of a previous owner.

This concept is crucial in transactions where no immediate gain or loss is recognized for tax purposes. Instead of recognizing a taxable event, the "tax history" of the asset, represented by its basis, is carried over or transferred, deferring the recognition of gain or loss until a later, taxable event occurs.

• Example 1: A Gifted Asset

  Imagine Sarah bought a rare coin for $5,000 many years ago. When the coin is now worth $20,000, she gives it as a gift to her nephew, David.

  For tax purposes, David's basis in the coin is Sarah's original basis of $5,000. If David later sells the coin for $22,000, his taxable gain will be calculated using this $5,000 substituted basis, not the $20,000 value at the time he received the gift. This illustrates a substituted basis derived from the asset's basis in the hands of a previous owner.

• Example 2: A Like-Kind Exchange of Real Estate

  An investor owns a rental property with a tax basis of $400,000. They exchange this property for another similar rental property of equal value in a "like-kind exchange" (a transaction allowed under Section 1031 of the Internal Revenue Code where certain property exchanges are not immediately taxable).

  The investor's basis in the new rental property becomes $400,000, which is the basis of the old property they exchanged. No gain or loss is recognized on the exchange itself. This is a substituted basis because the basis of the new asset is derived from the basis of a different asset (the old property).

• Example 3: Property Transferred to a Corporation

  A small business owner contributes a piece of equipment, which they purchased for $75,000, to their newly formed corporation in exchange for stock. The equipment is now worth $120,000.

  For tax purposes, the corporation's basis in the equipment is the owner's original basis of $75,000. This is a substituted basis because the corporation's basis in the equipment is derived from the basis it had in the hands of the previous owner (the business owner). The gain that might have been realized if the owner had sold the equipment to the corporation is deferred.