A Basic Introduction to Reverse Section 1031 Tax Deferred Exchanges

Here on HTW, we’ve spent considerable time and effort exploring the complexities of Section 1031 tax deferred exchanges. And this is for good reason: if performed correctly, a 1031 like-kind exchange can be an extremely useful wealth maximization tool. Like-kind exchanges not only allow taxpayers to defer the capital gain taxes which would normally be owed, they also allow more capital to be reinvested in the newly acquired property, and this leads to even greater returns. In other words, Section 1031 doesn’t just permit tax deferral, it allows your capital to work more effectively on your behalf. The clear financial benefits of Section 1031 explain the impressive rise in popularity of these transactions in recent years.

As if the existing complexity of 1031 were insufficient, it turns out that there are variations on the standard like-kind exchange which taxpayers may choose to conduct. One of these variations is known as a “reverse exchange.” Given the advantages which this variation can confer in certain contexts, reverse exchanges have become increasingly common. Let’s look more closely at the mechanics of reverse exchanges and then discuss some of the unique benefits of this type of transaction.

Basic Mechanics

In a standard – or “delayed” – exchange, the original property owned by the taxpayer is disposed of prior to the acquisition of the replacement property. In a reverse exchange, the order is flipped, and the replacement property is acquired first and the original property (the “relinquished property”) is sold subsequent to the acquisition of the replacement property. Superficially, this process seems simple, but other aspects of this variation make it considerably more complicated than a standard exchange.

Under current tax law, taxpayers are not permitted to simultaneously hold title to both the relinquished property and the replacement property. This makes intuitive sense, because simultaneous ownership of both properties would conflict with the basic exchange concept. In order to solve this problem, the entity facilitating the exchange for the taxpayer – referred to as the “qualified intermediary” – develops a separate corporate entity which exists solely to temporarily hold title to the replacement property prior to the disposition of the relinquished property. In 1031 nomenclature, the replacement property is “parked” in the entity and then title to the replacement property is transferred to the taxpayer after the relinquished property is sold. This parking arrangement has been approved by the IRS; in fact, the IRS has issued specific guidelines regarding the mechanics of these transactions.

Reverse exchanges also require more documentation and preparatory work compared to standard exchanges. The fees for these transactions are typically much higher given the additional complexity involved.

Unique Benefits

Reverse exchanges carry unique benefits for investors. Perhaps the most important of these benefits is the timing of the acquisition of the replacement property. The impetus for a reverse exchange usually relates to the desirability of the replacement property; the investor needs to close on the replacement property immediately, or else face the possibility of either losing it to another investor or receiving inferior financing. In some cases, investors know exactly which replacement property they want to acquire and simply haven’t arranged a buyer for their replacement property; but in many other cases, reverse exchanges are a response to market trends.

Another key benefit of reverse exchanges is the effective elimination of the identification requirement. In standard exchanges, replacement property ordinarily must be identified within 45 days after the closing of the relinquished property; reverse exchanges solve this issue from the outset because the replacement property is acquired first. Though it may seem like an easy enough rule to comply with, more than a few exchanges have failed simply because the investor could not properly identify a new property within the specific time window.

There’s much, much more to reverse exchanges, but this serves as a good introduction. In the future, we will go over the structure of reverse exchanges in greater detail and discuss further why they are uniquely beneficial for investors in many cases.

The Debate to Preserve or Eliminate Section 1031

Real Estate Exchange Property 1031 Section Tax Deferred

Real Estate 1031 Exchange

As lawmakers of the federal government struggle to deal with our ever-increasing national debt, Section 1031 of the Internal Revenue Code has come under scrutiny and may face extinction. Now that Republicans control both sides of the Congress (and the White House), Section 1031 could be seriously threatened if GOP lawmakers feel that reducing or eliminating the advantages of 1031 would prove financially beneficial for the nation as a whole. Discussions have surfaced previously about eliminating Section 1031, but current discussions appear to be more serious given the dire financial situation in which the country is encased.

Not all legislators view Section 1031 as a target for elimination; some lawmakers concur with many real estate professionals that 1031 actually contributes mightily to the national economy in a variety of ways. Let’s look at both sides of the debate in greater detail.

Section 1031 as a Tax Loophole

Under Section 1031, taxpayers are able to defer capital gains tax when they exchange their business or investment property for another property of like-kind (which essentially means another business or investment property). In practice, this can mean the deferral of hundreds of thousands ? and even millions ? of dollars in capital gains tax which would otherwise be collected by the federal government.

Though no lawmaker questions the permissibility of like-kind exchanges as they have developed under current regulations, there is doubt as to whether Section 1031’s true purpose was to defer gain in this particular way. The roots of Section 1031 stretch all the way back to 1921; at that time, however, the exchanges typically consisted of neighboring farmers who wished to swap their property in order to clarify property lines. Numerous common law opinions which occurred decades later shaped the current Section 1031 industry. Though it’s clear that like-kind exchanges do confer at least some benefits to the wider economy, it would be hard for even the most fervent 1031 supporter to deny that current like-kind exchanges are conducted with the same underlying purpose as those which occurred many decades ago.

Section 1031 as an Engine of Economic Activity

On the other side, many (if not most) professionals in the real estate industry contend that Section 1031 benefits the national economy in myriad ways. For one, they claim that Section 1031 encourages economic activity beyond the exchange itself in the form of construction services, title insurance services, real estate agent services, and so forth. Curtailing or eliminating Section 1031 would simultaneously reduce this related economic activity as well.

Furthermore, at least one formal study has concluded that the vast majority of like-kind exchanges eventually result in a taxable sale. In addition to supporting claims about the general economic benefit of 1031, a study by Professors David C. Ling (of the University of Florida) and Milena Petrova (of Syracuse University) stated that as high as 88 percent of exchanges ultimately result in taxable sales.

In our financially troubled state, Section 1031 faces arguably its toughest challenges. We shall have to wait and see whether this decades-old provision will either be preserved or meet its demise.

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Mercantile Trust Co. v. Commissioner & the Limited Importance of Contingencies

Real Estate Property Transaction Exchange

Real Property Exchange

Nearly every legal concept presently in use in these United States has an established pedigree. Very few of our concepts are recent inventions. This observation holds true not just in one or two areas of law but for quite literally our entire legal edifice. Section 1031 is no exception to this rule. Section 1031 is derived from a number of earlier tax acts which addressed the non-recognition of gains (or losses) when real property held for business or investment purposes is exchanged for like-kind property. Today, courts utilize the judicial opinions made in previous eras which were informed by one of these earlier tax acts. The case of Mercantile Trust Co. v. Commissioner (1935) is among the most significant of these opinions.

As we will see, Mercantile Trust Co. set an important precedent for viewing complex real property exchange transactions. Like the parties in Alderson v. Commissioner, the parties of Mercantile Trust Co. engaged in a complex transaction which involved multiple independent contracts, the use of an intermediary and a cash payment as “boot” on top of the exchange. In its opinion, the court emphasized that non-recognition depends primarily on what actually occurred, rather than on the various methods and motives which ultimately led to the transaction. Simply because a contingency could have given rise to a sale – and therefore would have created a taxable gain – does not necessarily bar non-recognition; the most important fact is whether an exchange of like-kind property actually transpired.

Facts

The representatives for Mercantile Trust Co. (the petitioners) appealed a judgment for a tax deficiency arising from a transaction involving Mercantile Trust Co., an intermediary (known as Title Guarantee & Trust Co.) and Emerson Hotel Co. The Commissioner of Internal Revenue (the respondents) claimed that the transaction amounted to a sale and that the petitioners had a recognized gain of $179,621 (approximately $2,521,070.02 when adjusted for inflation in 2016). The petitioners argued that the transaction had been an exchange of real property of like-kind within the scope of existing statutory provisions.

Title Guarantee & Trust Co., the intermediary, developed separate contracts with Mercantile and Emerson. To conclude certain of these contracts Title Guarantee made cash payments to the other party, and to conclude other contracts Title Guarantee accepted cash payments. Mercantile Trust Co. ultimately received the deed to the property (known as Lexington Street) originally held by Emerson Hotel Co. as well as a total of $24,426.90 in cash. Emerson Hotel Co. received the deed to the property originally held by Mercantile Trust Co. (known as Baltimore Street). Title Guarantee received commissions and title fees which added up to $8,573.10.

The respondents assessed the tax deficiency on the premise that Mercantile Trust Co. acquired the Lexington Street property in a separate transaction which should be considered a sale. The question before the court was whether the evidence on record supported this premise.

Law

The statutory provisions which applied to the case arose from section 112 of the Revenue Act of 1928. Section 112 (of the act of 1928) is the predecessor of section 1031 and includes many of the same provisions as the current law.

Ruling

The court (the U.S. Tax Court, known as the Board of Tax Appeals in 1935) ruled in favor of the petitioners and declared that the deficiency assessed by the Commissioner was without basis. The Commissioner argued that what had occurred was a “fictitious” exchange and that the Lexington Street property was acquired by Mercantile Trust Co. in an independent sales transaction. The tax court rejected this argument. The contract made between Mercantile Trust Co. and Title Guarantee included a contingency whereby Title Guarantee would pay $300,000 in cash in the event that the deed to the Lexington Street property could not be transferred. The court determined that this contingency did not negate non-recognition treatment given that an exchange of like-kind property did occur.

The reasoning employed by the tax court in Mercantile Trust Co. influenced later decisions, including the decision made in Alderson. The determination of non-recognition treatment depends heavily on the end result and not as much on the methods used to reach that result.

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Readers who enjoyed this piece about the famous case of Mercantile Trust Co. should check out our video on the tax perks of real estate ownership given by CPA Jessica Chisholm

Essential Points of the Principal Residence Exclusion

Real Estate Property Capital Gains Exclusion Residence

Excluded Capital Gains

In our first essay on section 1031 we promised to explore other sections of the tax code – namely, 1033 and 121 – which may be of interest to our readers. As always with HTC, we are true to our word. In this essay we will discuss some of the basic facts of section 121.

Section 121 is referred to as the “principal residence exclusion” because it allows gains derived from the sale of one’s primary residence to be excluded from taxable income (up to certain limits). Under 121, real property owners are permitted to exclude up to $250,000 in capital gains from the sale of their principal residence; married couples intending to file jointly may exclude up to $500,000.

In order to qualify for section 121 treatment, property owners must prove that they have owned and lived in the property for at least 24 months during the last 60 month period. It is not necessary that these 24 months be consecutive. Hence, under current law, it is theoretically possible to utilize section 121 once every 2 years.

Real property owners who wish to take advantage of section 121 have to keep a close eye on the market trends which affect the value of their property. As we know, property values tend to fluctuate throughout the course of ownership, and if the value rises too high then the property owner may end up having a significant tax liability even after section 121 is invoked. If a property’s value rises too high, converting the residence into a rental property and then utilizing section 1031 after a certain period of time has passed may be an optimal strategy.

In later installments we will cover section 121 in greater detail by examining legal cases and viewing examples of how section 121 has been utilized in real-world scenarios.

*It is worth mentioning that section 121 is the successor to section 1034. Section 1034 allowed taxpayers to defer 100 percent of the capital gain derived from the sale of their primary residence provided that they subsequently acquired another residence of equal or greater value. This section was replaced with the provisions of section 121 in 1997.

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Starker v. United States & the Qualifications of Internal Revenue Code Section 1031

Real Estate Property Capital Gains Section 1031

Real Estate Investment

Every real estate owner and investor should take the time to become acquainted with the elements of section 1031 of the Internal Revenue Code. This section allows taxpayers to defer recognition of either gain or loss when they exchange property of like-kind with another party. For any number of reasons, it may be wise for an owner or investor to exchange their property for another. Sans 1031, an exchange of real property would necessarily involve the realization of either gains or losses, and the management of such realization would require substantial investments of time and money. Section 1031 promotes a more open and free marketplace by eliminating the burdens which traditionally follow real estate sales.

Because of the heavy benefits it confers, section 1031 has rigid qualifications which are narrowly construed by courts. One case which illustrates the narrow reading of section 1031 qualifications is Starker v. United States (1977). As we will see, the plaintiff in this well-known case attempted to expand the construction of section 1031 so as to include a complex, multiyear financial transaction in which he took part. The court rejected the plaintiff’s attempt and set a precedent for a narrow construction of 1031.

Before hearing Starker, the court had just settled an earlier case, known was Starker I, which was heard in 1975 and involved the son and daughter-in-law of the plaintiff of the 1977 Starker case. The plaintiff’s son and daughter-in-law had also taken part in the same transaction which formed the basis for the suit of 1977; like the plaintiff, they tried to receive non-recognition of their capital gain under section 1031. The judge in Starker I concluded that the son and daughter-in-law correctly invoked section 1031 and were therefore entitled to a refund for taxes paid on the transaction. The next Starker case was heard by the same judge; this judge reconsidered his earlier decision and ruled against the plaintiff. As we’ve noted before, sometimes no amount of preparation can account for the whims of our magistrates.

Facts

The plaintiff transferred a very large amount of land – approximately 1,843 acres – to a company known as Crown Zellerbach Corporation. In return, the company created an “exchange value” balance on its books. To reduce the balance, the company was supposed to transfer a number of parcels of land to the plaintiff; as part of the agreement, these parcels did not need to be transferred all at the same time, but could be transferred one by one over the course of several years. Collectively, these parcels were supposed to be equal in value to the land given to the company by the plaintiff. The plaintiff also received a “growth factor,” which was interpreted as a type of interest by both the company and the court.

The plaintiff invoked section 1031 when filing the income tax return which included this transaction. The IRS denied this invocation and assessed a tax deficiency of $300,930.31 plus interest. The plaintiff then brought a suit to receive a refund.

The question before the court was whether the plaintiff was in fact entitled to non-recognition under section 1031 given the peculiar characteristics of his exchange.

Law

Under section 1031 of the Internal Revenue Code, taxpayers are entitled to non-recognition of capital gains or losses which arise from the exchange of property of like-kind. The exchange must be reciprocal and involve a present transfer of ownership; it cannot involve a promise to transfer property in the future.

Ruling

The court disallowed section 1031 and ruled in favor of the government. The court rested its decision on a number of factors. One factor was the element of time: the parties did not simultaneously exchange property of like-kind, but instead created a balance which was to be paid off incrementally over a period of time. And in the event that the parcels of land given to the plaintiff did not settle the balance after a period of five years, the agreement between the plaintiff and company held that the company would then transfer cash to cover the remainder. What’s more, two properties transferred by the company were not actually given directly to the plaintiff; the properties were given to the plaintiff’s daughter. And on another occasion, the plaintiff did not specifically receive the title to a property, but was given cash equal to the purchase price of the property along with the company’s right to acquire the property. These and other factors combined to provide a foundation on which the court made its decision to deny non-recognition treatment.

More than anything, our readers should use the Starker case to see the limited availability of section 1031. Where Starker applies, it can be an incredibly useful tool, but know that it only applies in scenarios which explicitly fall under its requirements.

In our upcoming installments, we will look at sections 1033 and 121 and highlight how these sections can also be of use to taxpayers.

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To learn more about the tax benefits of real estate ownership, please view our presentation by CPA Jessica Chisholm

United States v. Winthrop & the Test for Ordinary Income

Investment Property Real Estate Land Capital Gain

Investment Property

In our earlier article about the case of Byram v. United States (1983), we introduced the 7 pillars of capital gain treatment and discussed the recurring issue of distinguishing business sales from investment sales. In Byram, the court found the profits of multiple real estate transactions to be capital gains due to the peculiar facts which surrounded the transactions. In this article, we will discuss the specifics of an earlier case – United States v. Winthrop (1969) – in which the court rejected the capital gain classification and ruled that certain transactions were sales made in the ordinary course of business.

It is important that our readers have an understanding which is as clear as possible of what constitutes a capital gain so that they can avoid any unpleasant surprises. The facts of United States v. Winthrop contribute toward this understanding.

The case of United States v. Winthrop will also give readers a sense of the unpredictability in judicial reasoning. Prior to being heard by the Fifth Circuit Court of Appeals, the facts of this case were found to support a capital gain classification at the trial court; the Fifth Circuit actually had to overturn this finding to reach its conclusion. And given that there was no dispute between the trial court and appellate court over any matter of fact in the case, and that there were multiple potentially compelling cases cited by Winthrop, it follows that the outcome of even a strongly backed case cannot be predicted with mathematical certainty.

Facts

Over the course of a number of years, Mr. Winthrop (respondent in appellate case) inherited several pieces of real estate. Collectively, these pieces were referred to as “Betton Hills.” Mr. Winthrop inherited his first piece of land in 1932, and he began to develop that same piece a few years later in 1936. Mr. Winthrop inherited additional pieces of land at various other dates (1946, 1948 and 1960).

In 1936, Mr. Winthrop made his first sale by selling a portion of the land he had began developing earlier that same year. Mr. Winthrop continued to develop his land and sell portions of it to interested buyers up until his death in 1963. Hence, his sales operation spanned multiple decades. Though he did not create a business office, he devoted massive amounts of energy to developing the land so as to make it more marketable. What’s more, the income derived from real estate sales constituted the majority of his entire income for many years prior to his death. Mr. Winthrop also began to include “real estate” as his occupation for a number of years in official documents before his death. The question before the court was: should Mr. Winthrop’s activities receive capital gain treatment given the facts which underlay them?

Law

There are a number of common law tests which have been developed to aid the court in its determination of capital gain treatment. Though this is true, the court must also be certain to view each case as an independent matter and provide each case with its own analysis.

In United States v. Winthrop, there was no disagreement made by the Fifth Circuit regarding the fact that the land was held “primarily for sale” by Mr. Winthrop. The only remaining issue was whether the sales executed could be classified as sales made in the ordinary course of business. The Fifth Circuit stated that the ordinary course of business determination depends on whether selling the land was Mr. Winthrop’s primary purpose in holding the land.

Ruling

The Fifth Circuit overturned the trial court’s finding and determined that the sales made by Mr. Winthrop were made in the ordinary course of business and therefore should be disqualified from capital gain treatment. Mr. Winthrop clearly had a reasonably strong case given that he did not actively and aggressively advertise his properties, he did not maintain a sales office, did not reinvest his profits in other real estate (for the purpose of growing his business) and he initially acquired the real estate through inheritance rather than purchase. There were certainly many facts capable of supporting his position. Ultimately, the fact that Mr. Winthrop only used the properties for the purpose of selling to customers proved to be decisive.

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A Note on the Capital Gains Tax

Capital Gains Tax Rate Money Funds

Capital Gains

As the previous installment of Huddleston Tax Weekly made clear, our tax code draws a distinction between ordinary income and capital gains. In general, ordinary income is income derived throughout the course of running a business or trade; capital gains result from the sale of a “capital asset” (which is defined by the code). It is important for people to understand how their behavior will be classified because these classifications carry particular tax implications. In conjunction with criteria from the tax code, our common law also provides additional guidelines for classifying a given source of income.

The capital gains tax has long been the focus of controversy: many argue that its current low rate disproportionately benefits wealthy citizens and that it should be increased, while others contend that a lower rate actually stimulates more economic growth and that such growth benefits citizens of all socioeconomic levels. The evidence in favor of the latter position is considerable and should strike most objective observers as persuasive. The capital gains tax rate has fluctuated widely over the past several decades, and there is an unmistakable positive correlation between low rates and greater revenues generated from capital gains. This association may appear counterintuitive upon first glance, but a bit more scrutiny makes it very easy to understand: when the tax rate is high, people simply hold on to their assets and avoid paying the tax at a high rate; when the rate is low, people sell more frequently and this results in greater total revenues for the government.

Low rates also appear to influence stock market prices. The tax cuts in the 1980s, the late 1990s, and in 2003 all coincided with significant stock market gains. What’s more, there is also an association between reduced rates and business development as measured by initial public offerings (IPOs), money raised from IPOs and the money committed to venture capital firms. Investors are less willing to commit funds when capital gains tax rates are high; this agrees with common sense given that higher rates will result in smaller returns on investment.

Though lower capital gains tax rates do appear to provide greater benefits to the economy as a whole, there is no denying that such rates disproportionately benefit higher income levels. The clear majority of gains from capital asset sales are made by those with incomes above $200,000. Going forward, it appears that the debate on capital gains tax rates will be framed by this question: can our society accept the positive impact of lower rates even though lower rates tend to benefit wealthy individuals disproportionately?

References

Moore, Stephen. “Capital Gains Taxes.” David R. Henderson (ed.). Concise Encyclopedia of Economics. Indianapolis: Library of Economics and Liberty.

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Byram v. United States & the 7 Pillars of Capital Gain Treatment

Real Estate Property Transaction Sales Business

Real Estate Transactions

The tax code draws a distinction between ordinary income and income derived from the sale of a capital asset, or “capital gain.” In most instances, this distinction is straightforward and there is little confusion about whether income falls into one category or the other. Every now and then, however, a situation develops in which the classification of income is a difficult matter. There is much at stake in the determination of whether income is either ordinary or derived from the sale of a capital asset: capital gains can be taxed at substantially lower rates than ordinary income.

The case of Byram v. United States (1983) provides one example of the difficulty occasionally involved in distinguishing between a “business” sale – which would trigger ordinary income – and an investment sale. The tax code recognizes a number of general characteristics of business sales and investment sales; sometimes a transaction possesses characteristics of both a business sale and an investment sale, or it lacks enough characteristics of one type of sale to merit a definitive classification.

If you engage in real transactions with any kind of regularity, be sure that you’re aware of these characteristics so you can avoid any unpleasant surprises when tax time rolls around.

Facts

John Byram owned multiple pieces of real estate. Between the years 1971 and 1973, Byram sold a total of 22 pieces of real estate for a gross return of $9 million and a net profit of $3.4 million. He sold 7 pieces of real estate in 1973 alone.

Importantly, Byram did not have a business office; he did not advertise; he did not utilize the services of a broker; he did not subdivide the land; he spent only a small amount of time and effort engaging in the transactions; all of the transactions were initiated by the purchasers.

Law

The question of whether a transaction – or set of transactions – can receive “capital gain treatment” (and therefore be subject to the rates applicable to capital gains) depends on the characteristics of the transaction. Courts recognize the 7 “pillars” of capital gain treatment when deciding whether a given transaction should be deemed either an investment sale or business sale.

The 7 Pillars of Capital Gain Treatment can be summed up as follows: (1) purpose of the acquisition of the property and duration of ownership; (2) extent of the efforts to sell the property; (3) number, extent, continuity and magnitude of the sales; (4) time and effort devoted to developing the land and advertising to increase sales; (5) use of a business office; (6) degree of supervision exercised by the owner over any representative selling the property; (7) overall time and energy dedicated to the sales.

The question before the court was: do the transactions made by Byram between 1971-1973 merit capital gain treatment based on the guidelines established through the 7 pillars?

Ruling

The court (the Court of Appeals for the Fifth Circuit) affirmed the ruling of the lower court in favor of Byram. The transactions engaged in by Byram (and his buyers) possessed enough characteristics of an investment sale to trigger capital gain treatment. The determination of whether capital gain treatment is warranted requires an independent analysis for each individual case; in the Byram case it was clear that the evidence supported the conclusion that the properties were not sold as part of a business enterprise but as investments.

The Byram case is highly useful for people who own multiple pieces of real estate and who are considering selling these pieces in the future. It is important for these owners to be conscious of the facts of Byram so that they can be certain to receive capital gain treatment.

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Readers who enjoyed this essay should check out our presentation of the tax benefits of real estate ownership by CPA Jessica Chisholm

Understanding Cost Basis

Money Cost Basis

Cost Basis

Cost basis is a tax concept which is used for determining the true amount which has either been gained or lost from the sale of a given commodity. When you sell property, basis is used to compute the correct amount of tax which is owed from the sale. Though cost basis is a relatively simple concept, it can be a bit difficult to apply in some situations. In this essay we will discuss the fundaments of the concept and explain why it can be a bit trickier than it may seem upon first glance.

Simple Definition

The IRS provides a simple definition of cost basis on its 551 publication: “Basis is the amount of your investment in property for tax purposes. Use the basis of property to figure depreciation, amortization, depletion and casualty losses. Also use it to figure gain or loss on the sale or other disposition of property. … The basis of property you buy is usually its cost.”

Thus, in its simplest form, cost basis is the purchase price of your property. In the real world, however, cost basis is more subtle as the value of property tends to change over time; also, not all property is acquired through sale, and in cases where it is not acquired through sale computing cost basis is less straightforward.

Practical Definition

If a person buys an item — say a piece of furniture, such as a sofa — for $100, then $100 is the cost basis of the item (the sofa) at the outset. If the person decides to sell the sofa at a later date for $100, and the sofa has retained its original value of $100, then no tax is owed because no profit was realized. However, if the person managed to sell the sofa for $150, then a capital gain has been realized and therefore a tax is due (on the $50 of profit).

In other words, cost basis is a mechanism which is intended to offset one’s investment in property so that an individual is not unfairly taxed. If an individual were taxed for a sale even when no profit was realized, the commercial world would literally be turned topsy-turvy.

However, as mentioned previously, the computation of cost basis is not always straightforward. Seldom does the value of property remain fixed; in many cases the value fluctuates over time as the market goes up and down. An asset’s basis can decrease or increase depending on the way its value fluctuates over the course of its life. If an asset either improves or declines in value it acquires an adjusted basis which is then used to compute the correct amount realized from its sale.

Manner of Acquisition

When property is not acquired through a traditional sale the determination of its cost basis is more involved. For instance, when property is acquired through inheritance, the cost basis of the property is its fair market value at the time of the decedent’s death. And when property is transferred by gift or trust, the cost basis can either be directly carried over from the donor (i.e. transferred basis or carryover basis) or it can be the fair market value of the property. Hence, these other means of acquiring assets add complexity to the determination of cost basis.

Final Thoughts

Basis is a foundational concept in U.S. tax law as it is used constantly to determine the true amount owed from sales. Although it is simple to understand in its most basic applications, it can be a bit subtle depending on the particular circumstances. We will explore this interesting concept in greater depth in a later post.

Cost basis is particularly relevant for owners of real estate. Readers who own real estate should consider viewing the following presentation on the tax issues of real estate ownership

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