The basis of assets is the figure the IRS treats as your investment in a piece of property, and it decides how much tax you owe when you sell it, depreciate it, or otherwise let go of it. Under Section 1012 of the Internal Revenue Code, basis usually starts at cost: what you paid in cash, the debt you took on, and the value of anything else you gave up to get the asset. From there it moves. Improvements push it up. Depreciation, casualty deductions, and certain rebates push it down. Gifts, inheritances, exchanges, and divorce transfers each follow their own rule. And if you cannot prove your basis when it comes time to sell, the IRS can treat it as zero and tax the entire sale price as gain.1Internal Revenue Service. Publication 551 – Basis of Assets
Why the Number Matters
When you sell an asset, your taxable gain or loss is the difference between what you receive and your adjusted basis. Higher basis, smaller gain. Basis also sets the ceiling on depreciation deductions for business and rental property, and it determines whether some transactions produce tax at all.
The word “adjusted” is doing real work. Basis rarely stays at the original purchase number. It moves as long as you own the property, and the figure you use on your return is the adjusted basis on the day of sale, not the day of purchase.
Cost Basis When You Buy
For property you purchase, basis is what you paid: cash, the balance of any debt you assumed, and the fair market value of any other property or services you gave up. That figure is then increased by certain costs necessary to acquire the asset or place it in service, including sales and excise tax, freight and installation, legal and recording fees tied to securing title, and revenue stamps.2Internal Revenue Service. IRS Publication 551 – Basis of Assets
Real estate adds a layer. Certain settlement costs go into basis — title insurance, attorney fees connected to the purchase, and recording charges. Costs of financing do not. Mortgage points and mortgage insurance premiums stay out of basis. If you take over the seller’s mortgage, your basis includes both the cash you handed over and the outstanding loan balance you assumed.1Internal Revenue Service. Publication 551 – Basis of Assets
For stocks and bonds, basis is the purchase price plus commissions and transfer fees.3Internal Revenue Service. Topic No. 703 – Basis of Assets
Adjustments That Raise Basis
Capital expenditures increase basis. These are costs that add value, extend the property’s useful life, or adapt it to a new use. Permanent improvements like a new roof, an addition, or upgraded electrical wiring qualify. So do special assessments from a local government for sidewalks or sewer connections, legal fees for defending or perfecting title, and restoration costs after a casualty to the extent insurance did not cover them.
The line between a repair and an improvement is where people go wrong. Fixing a broken window is a repair, currently deductible on business property. Replacing every window in the building with new energy-efficient units is an improvement, added to basis and recovered through depreciation.
Adjustments That Reduce Basis
Basis is reduced by depreciation, casualty and theft loss deductions you have claimed, insurance reimbursements for those losses, and certain tax credits or rebates that count as adjustments to the purchase price.1Internal Revenue Service. Publication 551 – Basis of Assets Basis can never fall below zero.
Section 179 expensing and bonus depreciation each let a business write off a large portion of an asset’s cost up front. Both reduce basis dollar-for-dollar. A big first-year deduction feels good, but the low remaining basis translates directly into a larger taxable gain if you sell a few years later.
The “Allowed or Allowable” Trap
Section 1016 requires you to reduce your basis by depreciation that was “allowed or allowable.”4Office of the Law Revision Counsel. 26 U.S. Code 1016 – Adjustments to Basis “Allowable” is the word that bites. Even if you never claimed depreciation on a rental property, the IRS reduces your basis by the amount you could have claimed. When you sell, you owe tax on that phantom depreciation whether you benefited from it or not. If you never adopted a method, the statute defaults to straight-line for the allowable calculation. Skipping depreciation does not preserve basis. It just wastes the deduction.
Gifted Property
When someone gives you property, you inherit the donor’s tax history along with the asset. The general rule under Section 1015 is carryover basis: your basis equals the donor’s adjusted basis at the time of the gift.5Office of the Law Revision Counsel. 26 U.S. Code 1015 – Basis of Property Acquired by Gifts and Transfers in Trust If the donor’s basis was $50,000 and the property is worth $200,000 when handed to you, your basis is still $50,000.
The rule flips when the property has lost value. If the fair market value on the date of the gift is lower than the donor’s basis, you end up with two figures: the donor’s basis for measuring a future gain, and the lower fair market value for measuring a future loss.6Internal Revenue Service. Property Basis of Property Received as a Gift Sell for a price between the two, and you recognize neither gain nor loss. The dual-basis rule keeps donors from transferring unrealized losses to someone else.
Inherited Property
Inherited property runs on an entirely different rule. Under Section 1014, basis resets to the fair market value on the date of the decedent’s death.7Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent If the estate files a federal estate tax return and elects the alternative valuation date (six months after death), that later date’s value is used instead.8Internal Revenue Service. Gifts and Inheritances
This step-up wipes out a lifetime of appreciation for capital gains purposes. A parent buys stock for $10,000, it grows to $500,000, and the heir takes it with a $500,000 basis. Sell immediately and the taxable gain is close to nothing.
Community property states go further. When one spouse dies, the surviving spouse’s half of the community property also steps up, not just the decedent’s half, as long as at least half the value was includible in the decedent’s estate.9Internal Revenue Service. Publication 555 – Community Property
Property Received in a Divorce
Property transferred between spouses, or to a former spouse as part of a divorce, is treated as a gift for tax purposes under Section 1041. The recipient takes the transferor’s adjusted basis regardless of current market value, and no gain or loss is recognized on the transfer itself.10CCH AnswerConnect. 26 U.S. Code 1041 – Transfers of Property Between Spouses or Incident to Divorce
The practical consequence is easy to miss during a settlement. A $500,000 house with a $100,000 basis carries $400,000 of built-in gain. A $500,000 brokerage account with a $450,000 basis carries only $50,000. On paper they trade evenly. After tax, they do not.
Like-Kind Exchanges and Involuntary Conversions
In a like-kind exchange under Section 1031, you swap one piece of real property held for business or investment for another and postpone the gain.11Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment Your basis in the replacement property carries over from the property you gave up, so the deferred gain rides along in the form of a lower basis, waiting for the next sale.1Internal Revenue Service. Publication 551 – Basis of Assets Additional cash you pay in the exchange increases your basis. Exchange expenses such as attorney fees, brokerage commissions, and deed preparation costs also add to basis when no gain is recognized.
A related-party rule complicates things. If either party disposes of the exchanged property within two years, the exchange loses its tax-deferred treatment, and the basis of the property received resets to fair market value at the time of the original exchange plus associated expenses.
Involuntary conversions work the same way in spirit. If property is destroyed, stolen, or condemned and you buy similar replacement property with the insurance or condemnation proceeds, your basis in the replacement starts with the old basis, decreases by any unspent proceeds, and increases by any extra amount you put in.
Converting Personal Property to Business Use
When you begin using personal property for business or rental purposes, your depreciable basis is the lower of adjusted cost basis or fair market value on the date of conversion. That prevents you from depreciating a $30,000 figure on a personal car now worth $18,000. You depreciate the $18,000.
If the property has instead gone up in value, you use your original adjusted cost, not the higher current value. The appreciation does not help for depreciation, though it will still factor into gain on a future sale. For real estate being converted to a rental, an appraisal on the conversion date is worth its price, because the IRS can disallow depreciation deductions if you cannot support the fair market value you used.
Splitting Basis for Real Estate
Real estate needs its cost basis divided between land and structures, because only structures depreciate. Land does not wear out.1Internal Revenue Service. Publication 551 – Basis of Assets The allocation typically follows the relative fair market values of the land and buildings at the time of purchase, and the property tax assessment offers a starting reference point.
Once split, the building portion of basis drops each year through depreciation on a rental property. Over decades this creates a substantial taxable gain at sale even if the property never appreciated, because so much basis has been used up.
Stocks and Mutual Funds
When you own shares of the same stock bought at different times and prices, identifying which shares you sold decides your basis and your gain. The default is first-in, first-out, which treats the oldest shares as the ones sold.12Internal Revenue Service. Stocks, Options, Splits, and Traders Specific identification lets you choose the lot instead, controlling whether the gain is short- or long-term and how large it is.
Stock splits and stock dividends do not change your total basis. Own 100 shares with a $5,000 basis, get a 2-for-1 split, and you have 200 shares still totaling $5,000, at $25 per share instead of $50.
Mutual fund investors get a third option: average basis. Add up the total cost of all shares in the account, divide by the number of shares, and use the per-share figure.13Internal Revenue Service. Publication 550 – Investment Income and Expenses The method is available for shares of regulated investment companies and for shares acquired after 2011 through a dividend reinvestment plan. For covered securities (generally shares acquired after 2010), you elect average basis by written notice to the custodian and by notifying your broker. For noncovered securities, you make the election simply by using the method on your return for the first year it applies. Once elected for covered securities, revocation is allowed, but only before the earlier of one year after the election or the date of your first sale after it.
Keeping Records
The IRS expects records that substantiate basis for as long as they matter to a return that could still be examined. For property, that means keeping documents until the statute of limitations runs on the year you dispose of the asset. If you received the property in a nontaxable exchange, keep records on both the old and the new property until the limitations period closes on the year you finally sell the replacement.14Internal Revenue Service. How Long Should I Keep Records?
In practice this can mean holding paperwork for decades on real estate and other long-lived assets. Closing statements, receipts for improvements, depreciation schedules, gift tax returns, estate appraisals, and 1031 exchange documents all feed the basis calculation. Losing them does not change your legal basis, but proving that basis to the IRS becomes much harder, and the burden of proof is yours.