Will Your Taxable Gain Be Calculated Properly? Make Sure You Are Using The Correct Basis

The rules for basis, or the value of an asset used for computing tax gain or loss when an asset is sold or transferred, can be complicated. Here’s what you need to know.

Background on Basis

When a taxpayer sells an asset, such as shares of stock, capital gains tax may be owed on the difference between the purchase price (basis) and the sales price. For inherited assets, taxpayers receive “step up” tax basis to the value at the time of the benefactor’s death. The Internal Revenue Code allows certain inherited property to receive a new tax basis equal to the fair market value of the property as of the date of death. This means if appreciated inherited property is sold immediately, there will be no capital gain, or later, all pre-inheritance appreciation is excluded from taxation.

taxable gains differ for inherited versus gifted assetsProperty gifted during a taxpayer’s lifetime receives a carryover basis, that is, the gift recipient takes the same basis as that of the donor. This means the recipient of the gift takes the same tax basis in the property as it had when owned by the decedent. Consequently, the increase in value of the property that occurred during the decedent’s lifetime is subject to federal and state taxes when the property is sold.

Basis for Real Estate

Current law provides that the income tax basis of real estate owned by a decedent at death is adjusted (“stepped up” or “stepped down”) to its fair market value at the date of the decedent’s death. Real estate which is gifted causes the donees to have the same tax basis in the gifted real estate as that real estate’s basis would have been in the hands of the donor. There is an exception if the tax basis is greater than the fair market value at the time of the gift.

Partnership Interests

Adjustments to basis do not only occur as a result of death. When a taxpayer purchases an existing partner’s partnership interest, the amount paid becomes the basis for the purchaser’s partnership interest (“outside” basis). The new partner assumes the seller’s share of the partnership’s adjusted basis in its property (“inside” basis), commonly referred to as stepping in the shoes of the partner or capital account. If the partnership’s assets have appreciated substantially, the difference between the new partner’s inside and outside basis can be substantial.

The disparity between the inside basis and outside basis can deprive the incoming partner from depreciation deductions. To remedy this situation, the partnership may make a 754 election, which allocates the purchase price or fair market value of the partnership interest to the new partner’s share of partnership assets. If this election is made, additional depreciation and amortization resulting from the basis adjustment is specially allocated to the new partner, giving him or her additional tax deductions.  A 754 election must be made by the partnership.  Once made, it is binding on all future transfers of partnership interests.

The rules related to tax basis in assets upon death and purchase are complex and should be reviewed with a tax adviser. Contact me at [email protected] if I can assist you.