When we think of income taxes, we think of how much we earn. But, another aspect of income tax is the gain or loss on assets. Income tax basis is central to how assets are taxed in the United States.
This is the first of a series on income tax basis. This blog will examine income tax basis, how you get it, and how it gets adjusted. The next article will look at how income tax basis is important in estate planning.
Let’s look at the life of an asset and its income tax basis during that life. Mary bought a house for $300,000. This cost basis is the starting point of her income tax basis. If she makes certain improvements, such as a room addition or other capital improvements, these add to her basis. Let’s say she adds a bathroom for $50,000. Now her basis is $350,000.
Let’s say Mary lives in the house for two years and then sells it for $500,000. She would calculate her tax by subtracting her basis from the sale price. Her adjusted basis was $300,000 plus $50,000, or $350,000.
That is deducted from her sale price of $500,000, for a gain of $150,000. If this was just a vacation property she owned, she’d owe tax on the gain of $150,000. However, if Mary owned this as her principal residence, she could exclude up to $250,000 of the gain (double that if she were married), as long as she had owned and lived in the property for two of the prior five years. Since Mary owned and lived in the house for two years, she qualifies and, thus, doesn’t owe any tax on her gain of $150,000.
But what if Mary rented the property out? If Mary didn’t live in the home for two of the prior five years, she wouldn’t qualify to reduce her taxable gain. But, when she rented it out, she would have been able to depreciate the property. These depreciation deductions would be useful to offset the income she earned from renting the property. Let’s say Mary takes the standard depreciation deductions for two years, she’d have about $25,000 in deductions over the two years.
These depreciation deductions would also reduce her income tax basis from $350,000 to $325,000. (This assumes the entire value of the property was in the structure). If she rented the property over its life of 27.5 years, eventually she would depreciate it to zero. This depreciation can be very useful in offsetting the rental income she earns on the property over the years. However, when she sells the property, that depreciation gets “recaptured” as ordinary income, while the remainder of her gain is taxed as capital gains, which is typically taxed at a lower rate.
The above example looked at real estate. But other assets have an income tax basis, too. For example, investments like stocks have an income tax basis. Let’s say Mary buys five shares of stock for $10 per share, or $50. That’s her basis. The value of the stock increases to $1,000 per share, or $5,000. She sells the stock. She’ll owe tax on $5,000 less $50, or $4,950. The rate at which Mary will be taxed will depend on her other income.
Income tax basis can be very important in estate planning. It influences which assets you might want to give away and which assets you might want to keep. The next article in the series will examine how giving an asset or holding it until your death impacts the income tax basis your beneficiaries receive in the assets they receive.
Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128