CPA REG: Property Transactions and Basis Rules

Property Transactions and Basis for the CPA REG Exam

Basis is the foundation for calculating gain or loss on the sale or disposition of property. The CPA REG exam tests various basis rules extensively, including cost basis, adjusted basis, and special basis rules for gifted, inherited, and converted property. Mastering these rules is essential because they interact with nearly every other property transaction topic.

Cost Basis

The general rule under IRC Section 1012 is that the basis of property is its cost. Cost includes the purchase price plus all costs incident to the purchase, such as commissions, legal fees, recording fees, title insurance, and transfer taxes. For real property, cost basis includes amounts paid for the land and building. If the purchase includes both, the total cost must be allocated between the land (which is not depreciable) and the building based on their relative fair market values.

The cost of self-constructed assets includes materials, labor, and overhead. Interest on debt used to construct property may be capitalized under the uniform capitalization rules (IRC Section 263A). The basis of property acquired in a taxable exchange is the fair market value of the property received.

Adjusted Basis

The adjusted basis of property is the original basis increased by capital expenditures (additions, improvements, and betterments) and certain tax adjustments, and decreased by depreciation, amortization, depletion, casualty loss deductions, and other recovery of cost deductions. For the exam, always start with the original basis and apply all adjustments to arrive at the adjusted basis before calculating gain or loss.

Capital improvements must be distinguished from repairs and maintenance. Improvements add value, prolong the useful life, or adapt the property to a new use. Repairs merely maintain the property in its current condition. Improvements are capitalized and added to basis; repairs are currently deductible as business expenses (though the tangible property regulations provide additional rules for capitalization).

Basis of Gifted Property (IRC Section 1015)

The basis of property received as a gift depends on whether the property is sold at a gain or loss. For gain purposes, the donee uses the donor's adjusted basis (carryover basis). For loss purposes, the donee uses the lesser of the donor's basis or the fair market value at the date of the gift. If the property is sold for an amount between the donor's basis and the FMV at the date of the gift, no gain or loss is recognized.

The donee's basis for gain purposes is increased by any gift tax paid attributable to the net appreciation in the property at the time of the gift. The formula is: gift tax paid multiplied by (net appreciation divided by the taxable gift amount). The holding period of gifted property includes the donor's holding period if the donor's basis is used (tacked). If the FMV basis is used for a loss, the holding period begins on the date of the gift.

Basis of Inherited Property (IRC Section 1014)

Property acquired from a decedent generally receives a basis equal to the fair market value at the date of death (a stepped-up or stepped-down basis). If the executor elects the alternate valuation date under IRC Section 2032, the basis is the FMV six months after death (or the date of disposition if the property is sold or distributed within six months). All inherited property is treated as held long-term, regardless of how long the decedent or the heir held the property.

The step-up in basis eliminates any unrealized appreciation that existed at the time of death. This is why estate planning often involves holding highly appreciated assets until death rather than gifting them. Property held as community property receives a full step-up for both halves upon the death of one spouse.

Basis of Converted Property

When personal-use property is converted to business or investment use, the basis for depreciation and loss purposes is the lesser of the adjusted basis or the FMV at the date of conversion. The basis for gain purposes is the adjusted basis at the time of conversion. This dual-basis rule prevents taxpayers from converting property that has declined in value to business use in order to claim a loss deduction for the personal-use decline.

Basis in Nontaxable Exchanges

In nontaxable exchanges such as Section 1031 like-kind exchanges and Section 351 corporate formations, the basis of property received is generally a substituted basis equal to the basis of the property given up, adjusted for any gain recognized and any boot received or given. The substituted basis preserves the unrecognized gain or loss for future recognition when the replacement property is ultimately sold in a taxable transaction.

Allocation of Basis

When multiple assets are acquired in a single transaction (such as a lump-sum purchase), the total basis must be allocated among the assets based on their relative fair market values. In a business acquisition, IRC Section 1060 requires the residual method, allocating the purchase price among asset classes in a specific order (cash, certificates of deposit, receivables, inventory, other assets, Section 197 intangibles, and finally goodwill and going concern value).

Exam Tips

• Gifted property uses donor's basis for gain and lesser of basis or FMV for loss
• Inherited property gets FMV at date of death (or alternate valuation date)
• Converted property uses the lesser of basis or FMV at conversion for depreciation and loss
• Adjusted basis reflects all capital improvements and depreciation taken
• Substituted basis in nontaxable exchanges preserves unrecognized gain or loss
• Always allocate lump-sum purchase prices among individual assets