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

Image credit: PhotoAtelier

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