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Monday, December 28, 2009

Understanding Basis

If you want to sell an asset, particularly a valuable asset, no one should do so without first understanding what the tax consequences of that sale might be. The tax that most often affects the sale of a valuable asset (in a non-business setting), is the capital gains tax. To understand this capital gains tax consequence, you must first understand and appreciate the incredible importance of "Basis".

An asset's basis is often referred to as the amount an asset cost when you buy it. For example, if you buy stock at $20 and sell it at $100, the basis of the stock is $20 and the gain on the sale is $80. If the stock was held for an appropriate time amount, the gain would be considered capital gain and taxed at the capital gains tax rate.

Now, the basis in an asset can change for a variety of reasons. For example, let's say that the stock that you bought split, you would have to split the basis in the stock in the same way that the stock split. Additionally, let's say the asset is a house, or some other type of depreciable asset. Every time you depreciate the asset, the basis is reduced. If, on the other hand, you make capital improvements to the asset, like putting an addition on to a house, that increases the basis of the asset.

So, let's assume that you buy a rental property for $200,000. You spend $100,000 improving it, depreciate it by $80,000, and then ultimately sell it for $750,000. The basis in the property would be $220,000 ($200,000 + $100,000 - $80,000). The gain would be $530,000, and most likely taxed at the capital gains rate of 15%.

Another major factor in determining the basis in property is whether, under current law, a person holds that asset at the time of his or her death. Currently, when a person dies, the heirs take the assets of the decedent with a basis equal to fair market value. (Often times this is called a step up in basis - but that is a bit of a misnomer as the basis can actually be lower in a bad economy.)

So for example, let's say that Dad dies owning a house that he purchased for $350,000, and at the time of his death it is worth $550,000. If the heirs sell the house shortly after his death for $560,000, there is only $10,000 of gain, not $210,000 of gain because of the increase in basis due to Dad's death.

Now let's complicate matters. Dad and Mom own that same property that they bought for $350,000. Dad dies when the value of the property is $400,000 and Mom dies when the value is worth $550,000. The basis in the property will be determined by whom the property was left to. If Mom inherited the property from Dad and then died, the basis of the property is the full $550,000.

If Dad left the property to daughter, and the other half the property went to daughter when Mom died, the basis will be split. The basis will be $475,000 in the hands of daughter. (1/2 of the property with a $200,000 basis as a result of Dad's death and 1/2 of the property with a $275,000 basis as a result of Mom's death.)

I emphasized "under current law" earlier because that may all change on January 1, 2010. In 2001, President Bush passed a law that eliminates the federal estate tax and eliminates the fair market date of death basis rule. There will be another form of capital gains tax exemption that will go into affect that I review in another post.

Lost in the debate over the estate tax is the importance of the rule revaluing property so that it takes on a date of death basis. One of the big problems that people have is keeping proper records of the basis of their assets. Sometimes, assets can be passed down for generations before they are sold. If the owner cannot provide proof of an assets basis, the government will assume the basis is Zero, causing a potentially very large tax.

So while keeping track of the basis of your assets was always important, it may be even more important to safeguard your paperwork pertaining to your valuables if the estate tax is truly repealed.

1 comment:

10yearstogether said...

THank you SO MUCH for this very simple explanation of basis. I've always meant to getting around to writing a layman's terms summary of it to give to clients so they can take it home and digest the information. When I start discussing it in the office with them, it takes but a few minutes before their eyes are glossing over.