Cost basis
Encyclopedia
Basis as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation
. When property is sold, the taxpayer pays/(saves) taxes on a capital gain
/(loss) that equals the amount realized on the sale minus the sold property's basis.
The taxpayer deserves a tax-free "recovery" of the cost of acquiring a capital asset
, because this cost is analogous to a "business expense" used to acquire income. This recovery is postponed to the year of disposition because of a further analogy to the accrual accounting principle of matching expenses to revenues: disposing of property will deprive the taxpayer of a valuable asset, leaving a "hole" that should be filled by some form of tax-free recovery. The size of this "hole" is set to equal that asset's original cost, but doing so is not logically necessary; rather, it arises from the administrative decision to levy income tax on asset appreciation at the moment of sale, rather than as it appreciates (in which case, basis would equal amount realized and there would be no tax at disposition—since appreciation taxes were levied by constant assessments).
IRS
Publication 551 contains the IRS's definition of basis: "Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty loss
es. Also use it to figure gain or loss on the sale or other disposition of property."
Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals the purchase price. See IRC (Internal Revenue Code
) § 1012.
Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred basis (also called carryover basis). See IRC § 1015. Put simply, gifted assets retain the donor's basis. This means that the value of the asset at the time of transfer is irrelevant to computing the donee's new basis. The general rule does not apply, however, if at the time of transfer the donor's adjusted basis in the property exceeds its fair market value and the recipient disposes of the property at a loss. In this situation the asset's basis is its fair market value at the time of transfer. See Treas. Reg. § 1.1015-1(a)(1).
Assets acquired by inheritance: Assets acquired by inheritance receive stepped-up basis
, meaning the fair market value of the asset at the time of the decedent's death. See IRC § 1014. This provision shields the appreciation in value of the asset during the life of the decedent from any income taxation whatsoever.
Adjusted basis: An asset's basis can increase or decrease depending on changes that occur throughout its lifetime. For this reason, IRC § 1001(a) provides that computing gain requires determining the amount realized from the sale or disposition of property minus the adjusted basis. Capital improvements (such as adding a deck to your house) increase the asset's basis while depreciation deductions (statutory deductions that reduce the taxpayer's taxable income for a given year) diminish the asset's basis. Another way of viewing adjusted basis is to think of the asset as a savings account, with capital improvements representing deposits and depreciation deductions representing withdrawals.
Cost basis methods:
Average basis methods:
FIFO is the default method used if no other is specified, and generally results in the highest tax bill, as it sells oldest (hence generally most appreciated) shares first.
Average cost single category is widely used by mutual funds, as it is the simplest in terms of record keeping (only total basis need be tracked) and sale (no specifying required), and results in moderate tax.
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
. When property is sold, the taxpayer pays/(saves) taxes on a capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
/(loss) that equals the amount realized on the sale minus the sold property's basis.
The taxpayer deserves a tax-free "recovery" of the cost of acquiring a capital asset
Capital asset
The term capital asset has three unrelated technical definitions, and is also used in a variety of non-technical ways.*In financial economics, it refers to any asset used to make money, as opposed to assets used for personal enjoyment or consumption...
, because this cost is analogous to a "business expense" used to acquire income. This recovery is postponed to the year of disposition because of a further analogy to the accrual accounting principle of matching expenses to revenues: disposing of property will deprive the taxpayer of a valuable asset, leaving a "hole" that should be filled by some form of tax-free recovery. The size of this "hole" is set to equal that asset's original cost, but doing so is not logically necessary; rather, it arises from the administrative decision to levy income tax on asset appreciation at the moment of sale, rather than as it appreciates (in which case, basis would equal amount realized and there would be no tax at disposition—since appreciation taxes were levied by constant assessments).
IRS
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
Publication 551 contains the IRS's definition of basis: "Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion, and casualty loss
Casualty loss
A casualty loss is a type of tax loss that is a sudden, unexpected, or unusual event. Damage or loss resulting from progressive deterioration of property through a steadily operating cause would not be a casualty loss...
es. Also use it to figure gain or loss on the sale or other disposition of property."
Determining basis
For federal income taxation purposes, determining basis depends on how the asset in question was acquired.Assets acquired by purchase or contract: For assets purchased or acquired contractually, the basis equals the purchase price. See IRC (Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
) § 1012.
Assets acquired by gift or trust: The general rule is that assets acquired by gift or trust receive transferred basis (also called carryover basis). See IRC § 1015. Put simply, gifted assets retain the donor's basis. This means that the value of the asset at the time of transfer is irrelevant to computing the donee's new basis. The general rule does not apply, however, if at the time of transfer the donor's adjusted basis in the property exceeds its fair market value and the recipient disposes of the property at a loss. In this situation the asset's basis is its fair market value at the time of transfer. See Treas. Reg. § 1.1015-1(a)(1).
Assets acquired by inheritance: Assets acquired by inheritance receive stepped-up basis
Stepped-up basis
Stepped-up basis is the term used to describe the basis of property that a taxpayer receives from a decedent under the Internal Revenue Code § 1014.- General rule :...
, meaning the fair market value of the asset at the time of the decedent's death. See IRC § 1014. This provision shields the appreciation in value of the asset during the life of the decedent from any income taxation whatsoever.
Adjusted basis: An asset's basis can increase or decrease depending on changes that occur throughout its lifetime. For this reason, IRC § 1001(a) provides that computing gain requires determining the amount realized from the sale or disposition of property minus the adjusted basis. Capital improvements (such as adding a deck to your house) increase the asset's basis while depreciation deductions (statutory deductions that reduce the taxpayer's taxable income for a given year) diminish the asset's basis. Another way of viewing adjusted basis is to think of the asset as a savings account, with capital improvements representing deposits and depreciation deductions representing withdrawals.
Mutual Fund Basis Methods
For mutual funds, there are 4 basis methods approved by the IRS, detailed in Publication 564:Cost basis methods:
- Specific share identification
- First-in, first-out (FIFOFIFOFIFO is an acronym for First In, First Out, an abstraction related to ways of organizing and manipulation of data relative to time and prioritization...
)
Average basis methods:
- Average cost single category (ACSC)
- Average cost double category (ACDC)
Evaluation of methods
Specific share identification is the most record and labor intensive, as one must track all purchases and sales and specify which share was sold on which date. It almost always allows the lowest tax bill, however, as one has discretion on which gains to realize.FIFO is the default method used if no other is specified, and generally results in the highest tax bill, as it sells oldest (hence generally most appreciated) shares first.
Average cost single category is widely used by mutual funds, as it is the simplest in terms of record keeping (only total basis need be tracked) and sale (no specifying required), and results in moderate tax.