How is the basis of property determined for income tax purposes?

Basis usually starts out as equal to cost plus any additions or improvements paid over the life of the property.  There are exceptions to this general rule however.

Property that is inherited receives a stepped up basis or a stepped down basis to the fair market value of the property as of the date of the decendent’s death.  Property that is gifted to someone carries the same basis as that of the donor of the gift, unless the fair market value is lower than the donor’s basis, and in that instance the basis is stepped down to the fair market value.

However, gain or loss is measured against adjusted basis, and basis may be adjusted by many things. Among the adjustments to basis are depreciation and items required to capitalized, or additional investments made into a business.

One of the more complicated areas of basis is basis in a business that is a pass through entity such as an S-Corporation or Partnership.  With a pass through entity the income from the entity flows through, via a Schedule K-1 to the personal tax return of the shareholder or partner.   Its is necessary to have basis in order to take non-income distributions or to take losses.  A partner or shareholder’s initial basis in a company is the amount that they invested in the company in either money or goods.  That basis changes, either growing or declining, over the years, based on profits earned, losses, additional investments, etc.

Example:  Mary decides to open a business providing cleaning services to commercial properties and sets up an S-Corporation for the business.  She invests $10,000.00 into the business and hires employees.  This $10,000 is her starting basis in the business. In the first year of business, she has a $11,000.00 loss.  That loss will flow through to her personal return via a Schedule K-1. However she will only be able to deduct $10,000 of that loss on her personal return, as she has only $10,000 in basis.  The basis in her S-Corporation will change from year to year based on new investments in the business, losses, and profits retained.

Case Studies: Understanding Basis for Income Tax Purposes

Case Study 1: Inherited Property

In this case, Sarah inherits a property from her late grandfather. The basis of the property is stepped up to the fair market value at the time of her grandfather’s death. This case study highlights how the basis for income tax purposes can be determined differently for inherited property compared to other situations.

Case Study 2: Gifted Property

John receives a property as a gift from his aunt. The basis of the property carries over from the donor, his aunt, unless the fair market value is lower than the aunt’s basis. In that case, the basis is stepped down to the fair market value. This case study demonstrates how the basis for income tax purposes can be affected by gifted property.

Case Study 3: Basis in a Pass-Through Entity

Mary starts an S-Corporation for her cleaning services business. She invests $10,000 into the business, which becomes her initial basis. Over the years, the basis in her S-Corporation changes based on profits, losses, and additional investments. This case study highlights the importance of basis in a pass-through entity for taking non-income distributions or claiming losses.