This Thing Called Basis?
This month’s financial planning article deals with excluding the gain on the sale of a personal residence, but just exactly how do you determine the gain on the sale of your home? For that matter, how do you determine whether you have a tax gain on the sale of any asset?
The simple answer to the question is to say that your gain is equal to the proceeds of the sale of your asset, less related expenses, less your basis in the asset. Unfortunately, that simple definition bypasses one small problem - what is the definition of the word basis? If you ever listened to the song This Thing Called Love, you get a sense of how complicated it is to define that word "love" - and the same can be said of the term basis, though it’s not quite that nebulous.
This article is intended to help you get a sense of what your basis is in the assets you own.
A Rose by Any Other Name…
…is still a rose and another name you might substitute for basis is cost because that is your starting point in determining your basis in an asset. Of course, the cost of an asset is what you pay for it, but how much did you pay for that house over on Elm Street that the developers want to turn into a parking lot for the new mall? Is it just the cash portion of what you paid? What about the money you borrowed to buy the house? Do you get to include any of that?
The answer to the question is yes, you can include the debt you incurred to buy the asset. In fact, the general rule is that the cost of any asset is the cash you paid up front plus any debt assumed in exchange for the property, but that’s just the beginning of determining your basis.
Improving Your Asset
In many instances, the asset you purchase will not be what you sell. In the case of real estate investments, you can add the cost of improvements to the property. An improvement is an expenditure that increases the value or adds life to the property. For example, if you bought the house you now live in and added substantially to the landscaping, the cost of the landscaping would be added to your original cost in determining the basis for calculating your gain (or loss) upon sale. Similarly, remodeling expenditures would add to your basis. Be careful, though, not to include simple repairs or replacements as if they were improvements. Weekly lawn maintenance does not equate to landscaping that can be added to your basis.
Time Takes Its Toll on Us All
Just like time takes it’s toll on our bodies, it also takes its toll on equipment, real estate and other assets. The way the tax code takes this into account is by allowing you to depreciate the cost of your investment or trade-or-business asset over its estimated useful life (assuming it’s the kind of property that can legally be depreciated). For example, assume you bought a tractor last year and you are depreciating it over seven years. The cost of the tractor was $21,000 and you took a $3,000 deduction for depreciation ($21,000 divided by 7). Your basis if you sold the tractor would be $18,000 ($21,000 - $3,000). The actual depreciation for tax purposes isn’t quite that easy to calculate, but you get the idea.
This rule only applies to assets used in a trade or business and property held for the production of income. Unless you use part of your home for business purposes, you don’t get a depreciation deduction each year. The same thing is true of other non-business assets.
Let’s recap what we’ve learned so far. The basis in an asset you sell is what you paid for it, plus the cost of any improvements, less any depreciation you have deducted. See how simple it is to compute basis?
Okay, that’s a trick question. It’s a trick question because there can be other factors, like if you traded one asset for another in a tax-free transaction and a number of other twists and turns the tax code throws at you in certain circumstances. If you’re thinking of selling an asset and don’t quite know how to determine what your taxable gain will be, give us a call. We can help you determine the basis of your asset and the tax ramifications of the sale.
Enjoy America’s birthday this month and be careful at the birthday party.