Legal Definitions - tax basis

Tax basis refers to the value of an asset used for tax purposes. It's essentially your investment in a property or item, which helps determine how much profit (or loss) you've made when you eventually sell or exchange it. The primary goal of calculating tax basis is to ensure you are only taxed on the gain you realize, not on the return of your original investment.

Initially, your tax basis is usually the purchase price of an asset, plus any additional costs incurred to acquire it and get it ready for use. These can include things like sales taxes, shipping fees, installation costs, or commissions. Over time, this initial basis can be adjusted upwards or downwards, creating what's known as your adjusted basis. For instance, significant improvements to a property would increase its basis, while claiming depreciation deductions on a business asset would decrease it.

When you sell an asset, your taxable profit (or capital gain) is calculated by subtracting your adjusted tax basis from the sale price. This prevents you from being taxed on the money you originally spent to acquire the asset.

• Example 1: Selling a Renovated Home

  Imagine Sarah bought a house for $300,000. Over the years, she spent $50,000 on a major kitchen renovation and added a new roof for $20,000. Her initial tax basis was $300,000. The improvements increase her basis, so her adjusted tax basis becomes $300,000 (original purchase) + $50,000 (kitchen) + $20,000 (roof) = $370,000.

  Later, Sarah sells the house for $450,000. To calculate her taxable gain, she subtracts her adjusted basis from the sale price: $450,000 (sale price) - $370,000 (adjusted basis) = $80,000. Sarah would only be taxed on this $80,000 profit, not the entire $450,000 sale price, because her tax basis accounts for her original investment and subsequent improvements.

• Example 2: Selling Stock with Brokerage Fees

  David purchased 100 shares of a company's stock for $50 per share, totaling $5,000. He also paid a $25 commission to his broker for the transaction. His initial tax basis for these shares is $5,000 (purchase price) + $25 (commission) = $5,025.

  Years later, David sells all 100 shares for $75 per share, receiving $7,500. To determine his taxable gain, he subtracts his tax basis: $7,500 (sale price) - $5,025 (tax basis) = $2,475. David's tax liability will be based on this $2,475 profit, as his tax basis properly reflects his total cost of acquiring the investment.

• Example 3: Selling Depreciated Business Equipment

  A small manufacturing company, "Innovate Corp.," bought a new piece of machinery for $100,000. They also paid $2,000 for shipping and $3,000 for professional installation. Innovate Corp.'s initial tax basis for the machinery is $100,000 (purchase price) + $2,000 (shipping) + $3,000 (installation) = $105,000.

  Over the next five years, Innovate Corp. claimed $40,000 in depreciation deductions on this machinery for tax purposes. These deductions reduce the asset's value on paper and lower its tax basis. So, the adjusted tax basis becomes $105,000 (initial basis) - $40,000 (depreciation) = $65,000.

  If Innovate Corp. then sells the machinery for $70,000, their taxable gain would be $70,000 (sale price) - $65,000 (adjusted basis) = $5,000. The adjusted basis ensures that the company is taxed on the actual economic gain, taking into account the tax benefits they already received through depreciation.