Determination of Basis
The basis of an asset is the starting point for calculating gain or loss on its sale or disposition. How basis is determined depends on how the taxpayer acquired the property — by purchase, gift, inheritance, or conversion.
Purchased Property
When a taxpayer purchases property, the basis is simply the cost of the property. Cost includes the purchase price plus all amounts paid to acquire the asset and make it ready for its intended use.
Cost basis includes:
- Purchase price
- Sales tax
- Freight and installation charges
- Legal fees related to acquisition
- Recording fees and transfer taxes
Adjusted Basis
Over time, the original cost basis is modified to produce the adjusted basis:
Example: Bear Co. purchases a delivery truck for $40,000 and pays $2,000 for sales tax and delivery charges. The initial cost basis is $42,000. After 3 years, Bear Co. has claimed $18,000 in MACRS depreciation. The adjusted basis is $42,000 − $18,000 = $24,000.
Holding Period
For purchased property, the holding period begins the day after the acquisition date. If Jamie buys stock on March 1, the holding period begins on March 2.
Gifted Property
When property is received as a gift, the basis rules depend on whether the donee later sells at a gain or a loss.
Gain Basis (Carryover Basis)
If the donee sells the gifted property for more than the donor's adjusted basis, the donee uses the donor's adjusted basis (carryover basis). The donor's holding period also tacks on — it carries over to the donee.
Loss Basis (FMV Rule)
If the FMV at the date of the gift is less than the donor's adjusted basis, a special dual-basis rule applies:
- If the donee sells at a gain (above donor's basis): use the donor's basis
- If the donee sells at a loss (below FMV at the date of the gift): use the FMV at the date of the gift
- If the donee sells for an amount between the donor's basis and the FMV at the gift date: no gain and no loss is recognized (the "limbo" zone)
Example: Sarah receives stock as a gift from her uncle. The uncle's adjusted basis was $10,000, and the FMV on the gift date was $7,000.
- If Sarah sells for $12,000 → Gain of $12,000 − $10,000 = $2,000 gain (uses donor's basis)
- If Sarah sells for $5,000 → Loss of $5,000 − $7,000 = $2,000 loss (uses FMV at gift date)
- If Sarah sells for $8,500 → The sale price falls between $7,000 and $10,000 → No gain or loss
Holding Period for Gifts
- If using the donor's carryover basis (gain situation): the donor's holding period tacks on to the donee's
- If using FMV at the gift date (loss situation): the holding period begins on the date of the gift
A quick way to remember the gift basis rule: Gains use the donor's basis; losses use FMV. If the sale price is in the middle, it's a wash.
Inherited Property
When a taxpayer inherits property, the general rule is that the basis is "stepped" to the value of the asset at the time of the decedent's death. This is a crucial concept for the CPA exam, as it differs significantly from the carryover basis rules used for gifted property.
1. The General Rule: Step-Up (or Step-Down) to FMV
In most cases, the basis of inherited property is the Fair Market Value (FMV) at the date of the decedent's death.
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Step-Up: If the property appreciated (e.g., the decedent bought it for $10,000 and it was worth $50,000 at death), the heir's basis is $50,000. The $40,000 of appreciation is never taxed.
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Step-Down: If the property declined in value (e.g., the decedent bought it for $10,000 and it was worth $8,000 at death), the heir's basis is $8,000. The $2,000 pre-death loss disappears and cannot be claimed by anyone.
2. The Alternative Valuation Date (AVD)
The executor of an estate may elect an Alternative Valuation Date to value all estate property. This election is only available if it decreases both the total gross estate value and the estate tax due.
If the AVD is elected, each asset's basis equals its FMV at the earlier of:
- Six months after the date of death, or
- The date the asset is distributed or sold (if that occurs before the six-month mark).
Example:
- FMV at date of death: $100,000
- FMV six months later: $90,000
If the executor validly elects AVD, the heir's basis is $90,000.
The AVD election applies to all estate assets — the executor cannot cherry-pick which assets to value at the AVD.
3. The Automatic Long-Term Holding Period
Regardless of how long the decedent owned the property or how long the heir holds it before selling, inherited property is automatically deemed to have a long-term holding period.
Even if the decedent bought stock one day before dying and the heir sells it one day after inheriting it, any gain or loss is treated as a long-term capital gain or loss (LTCG/L).
4. Comparison: Gifted vs. Inherited Property
| Feature | Gifted Property | Inherited Property |
|---|---|---|
| Basis Rule | Carryover (donor's) basis | FMV at date of death |
| Holding Period | "Tacks on" from donor's acquisition date | Always long-term |
| Loss Rule | Dual basis: lower of adjusted basis or FMV at date of gift | FMV at death (step-down permanently eliminates the loss) |
:::caution Common Pitfall
On the CPA exam, do not confuse gifted and inherited property. A gift uses the donor's carryover basis; inherited property uses FMV at death. These rules are frequently tested together.
:::
5. Exception: Income in Respect of a Decedent (IRD)
The step-up (or step-down) rule does not apply to assets that constitute Income in Respect of a Decedent (IRD). IRD items are amounts the decedent had earned or was entitled to receive but had not yet recognized for income tax purposes before death.
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Common examples: Traditional IRAs, 401(k)s, uncollected wages, accrued interest, and installment sale receivables.
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Tax treatment: The heir takes the decedent's basis (typically $0 for pre-tax retirement accounts) and pays ordinary income tax on distributions, just as the decedent would have.
IRD assets are still included in the decedent's gross estate for estate tax purposes, but the heir does receive a deduction for the estate taxes attributable to the IRD item (the "IRD deduction" under IRC §691(c)), which partially offsets the income tax burden.
Capitalize or Expense
When a business incurs a cost, a critical question is whether the expenditure should be capitalized (added to the basis of an asset and recovered over time through depreciation or amortization) or expensed (deducted immediately in the current year).
General Rule
If the expenditure creates or improves an asset with a useful life greater than one year, it must be capitalized. If it merely maintains existing property in its current operating condition, it is generally an expense.
| Capitalize | Expense |
|---|---|
| Improvements (betterments, restorations, adaptations) | Routine repairs and maintenance |
| Additions to property | Supplies used and consumed in the year |
| New roof, HVAC system, structural modifications | Painting, patching, cleaning |
Materials and Supplies
A taxpayer may deduct amounts paid for materials and supplies if the item meets either of these criteria:
- The item costs $200 or less, or
- The item has a useful life of 12 months or less
Items that do not meet either threshold must be capitalized.
De Minimis Safe Harbor Election
Taxpayers may elect to expense items that would otherwise be capitalized if the cost per item (or per invoice) does not exceed a specific threshold:
| Taxpayer Type | Threshold Per Item |
|---|---|
| Taxpayer with an Applicable Financial Statement (AFS) (e.g., audited financials) | $5,000 |
| Taxpayer without an AFS | $2,500 |
Example: Gies Co. has audited financial statements and purchases 20 laptops at $2,400 each for employee use. Because Gies Co. has an AFS and each laptop costs less than $5,000, the company may elect to deduct the entire $48,000 under the de minimis safe harbor rather than capitalizing and depreciating each laptop.
The de minimis safe harbor is an annual election made on the tax return. The taxpayer must have a written accounting policy in place at the beginning of the tax year to capitalize amounts below the threshold on its books.
Property Converted from Personal to Business Use
When a taxpayer converts personal-use property (e.g., a personal residence) to business or income-producing use (e.g., a rental property), special basis rules apply because losses that accrued during personal use are not deductible.
Depreciation Basis
The basis for computing depreciation on the converted property is the lesser of:
- The taxpayer's adjusted basis at the date of conversion (original cost + improvements − any depreciation, though personal-use property has none), or
- The FMV of the property at the date of conversion
Gain and Loss Basis
| Purpose | Basis Used |
|---|---|
| Computing gain on a later sale | Original cost basis (adjusted for depreciation taken after conversion) |
| Computing loss on a later sale | Lesser of cost or FMV at date of conversion (adjusted for depreciation) |
Example: Marcus purchased a home for $300,000. He later converts it to a rental when the FMV is $250,000.
- Depreciation basis: Lesser of $300,000 (cost) or $250,000 (FMV) = $250,000
- If Marcus later sells for $350,000 after claiming $30,000 in depreciation:
- Gain basis = $300,000 − $30,000 = $270,000 → Gain = $350,000 − $270,000 = $80,000
- If Marcus later sells for $200,000 after claiming $30,000 in depreciation:
- Loss basis = $250,000 − $30,000 = $220,000 → Loss = $200,000 − $220,000 = ($20,000)
The conversion rules prevent taxpayers from claiming a loss that is attributable to a decline in value during personal use. Only losses that occur after the conversion to business use are deductible.
Intangible Property
Purchased Intangibles
When a taxpayer purchases an intangible asset (such as a patent, trademark, copyright, or goodwill), the basis is the cost of the intangible. If the intangible is acquired as part of a business purchase, the amount allocated to the intangible under IRC §1060 becomes its basis.
Most purchased intangibles that are part of a business acquisition (IRC §197 intangibles) are amortized over 15 years using the straight-line method.
Organizational and Start-Up Costs
When a new business is formed, it may incur organizational costs (costs of creating the legal entity) and start-up costs (costs incurred before the business begins operations).
Each category is treated the same way:
- The taxpayer may immediately deduct up to $5,000 in the first year
- The $5,000 deduction is reduced dollar-for-dollar for costs exceeding $50,000 (fully phased out at $55,000)
- Any remaining costs are amortized over 180 months (15 years), beginning in the month the business starts operations
| Cost Type | Examples |
|---|---|
| Organizational costs | Legal fees for drafting articles of incorporation/partnership agreements, state filing fees, accounting fees for setting up the entity's books |
| Start-up costs | Market research, employee training before opening, advertising for the grand opening, consultant fees for site selection |
Example: Illini Entertainment, a new LLC, incurs $8,000 in organizational costs and $42,000 in start-up costs.
- Organizational costs: Deduct $5,000 immediately; amortize the remaining $3,000 over 180 months ($16.67/month)
- Start-up costs: Deduct $5,000 immediately; amortize the remaining $37,000 over 180 months ($205.56/month)
Organizational and start-up costs are treated as separate categories — each gets its own $5,000 deduction and 180-month amortization. Do not combine them.