Tax Basis of Assets: Complete CPA REG Exam Guide

Understanding Tax Basis for CPA Candidates

The tax basis of an asset is the foundation for computing gain or loss on disposition and for calculating depreciation deductions. Determining the correct basis is one of the most fundamental skills tested on the CPA REG exam. Basis rules differ depending on how the asset was acquired: by purchase, gift, inheritance, exchange, or conversion from personal to business use.

Cost Basis: The Starting Point

Components of Cost Basis

The cost basis of purchased property generally equals the amount paid for the asset, including cash, the fair market value of other property given, and any liabilities assumed. In addition, the following costs are added to basis: sales tax, freight and installation charges, testing and setup costs, legal fees related to the acquisition, recording fees, and title insurance. The cost basis also includes amounts paid to make the property ready for its intended use.

Costs that are not added to basis include amounts deducted currently (such as interest and property taxes during construction that are not required to be capitalized), personal expenditures, and amounts that are otherwise not capitalizable. For real property, basis includes settlement fees, abstract fees, recording fees, transfer taxes, and title insurance.

Adjusted Basis

After acquisition, basis is adjusted upward for capital improvements and certain other capitalized expenditures, and downward for depreciation, amortization, depletion, casualty loss deductions, and other returns of capital. The result is the "adjusted basis," which is the figure used to compute gain or loss upon disposition.

Basis of Gifted Property

The Dual Basis Rule

When property is received as a gift, the basis depends on whether the property has appreciated or declined in value. If the fair market value (FMV) at the date of the gift is greater than or equal to the donor's adjusted basis, the donee takes the donor's adjusted basis (carryover basis). The donee's basis may also be increased by any gift tax paid that is attributable to the net appreciation in the property.

If the FMV at the date of the gift is less than the donor's adjusted basis, a dual basis rule applies. For determining gain, the donee uses the donor's carryover basis. For determining loss, the donee uses the FMV at the date of the gift. If the donee sells the property for an amount between the FMV and the donor's basis, no gain or loss is recognized.

Gift Tax Adjustment to Basis

When the donor pays gift tax on the transfer, a portion of the tax may be added to the donee's basis. The adjustment equals the gift tax paid multiplied by the ratio of the net appreciation (FMV minus donor's adjusted basis) to the amount of the taxable gift. This adjustment applies only to gifts where the FMV exceeds the donor's basis.

Basis of Inherited Property

Property acquired from a decedent generally receives a basis equal to its fair market value on the date of the decedent's death, or on the alternate valuation date (six months after death) if the executor elects alternate valuation under Section 2032. This "stepped-up" (or "stepped-down") basis eliminates the built-in gain or loss that existed at death. Community property receives a full step-up in basis for both halves of the property.

Exceptions to the stepped-up basis rule include income in respect of a decedent (IRD), such as unpaid compensation and IRA distributions, which retains the character it would have had if the decedent had lived. Property gifted to the decedent within one year of death that passes back to the original donor (or the donor's spouse) takes the decedent's adjusted basis rather than the FMV step-up.

Basis in Like-Kind Exchanges (Section 1031)

In a like-kind exchange of real property held for productive use in a trade or business or for investment, the basis of the property received equals the adjusted basis of the property given up, decreased by any boot (cash or non-like-kind property) received and increased by any gain recognized and any boot paid. This substituted basis preserves the deferred gain or loss.

Basis of Converted Property

When property is converted from personal use to business or rental use, the basis for depreciation purposes is the lesser of the adjusted basis at the time of conversion or the FMV at the time of conversion. For determining gain, the original adjusted basis is used. For determining loss, the lower FMV at conversion is used. This prevents taxpayers from deducting personal losses through depreciation.

CPA Exam Tips

• Always identify how the property was acquired before determining basis.
• For gifts, remember the dual basis rule and the possibility of a "no gain, no loss" zone.
• Inherited property gets FMV at death or alternate valuation date.
• Converted property uses the lesser of adjusted basis or FMV for depreciation.
• In Section 1031 exchanges, basis of property received is a substituted basis.