What is Tax Basis? Definition and Setup

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Profit and loss are one of the most basic business concepts. But when tax time comes, these simple concepts can get much more complicated. This happens because the amount of profit or loss you have from the sale of an asset directly affects your tax bill. But by how and by how much?

To figure this out, you need to determine your tax basis. The basics of this concept are relatively easy. However, it’s important to understand how unique situations can affect your tax basis in certain situations, as these can get a bit more complicated.

Keep reading to find out what tax basis is and how to use it to set yourself up for the right financial decisions.

Related: What Are Tax Incentives? Beginner’s Guide For 2023

Why Do You Need to Know the Tax Basis?

Understanding your tax basis is critical to determine your tax bill accurately. The basis determines if you have a gain or a loss when you sell an asset and how much the profit or loss is. This is then used to determine how much tax you owe due to the asset’s sale.

If you have a higher basis, you have a smaller gain as the difference between what you paid and what you sold it for is less. This, in turn, leads to a smaller tax bill.

What Is Tax Basis?

Tax basis is your capital investment in an asset for tax purposes. You can think of it in many cases as how much money it costs to obtain an asset. For example, if you are figuring out your tax basis for a piece of equipment, your basis will include the asset’s purchase price. But, you also add additional costs of obtaining the equipment, including sales tax, commissions, and transfer or recording fees when applicable.

You might also hear tax basis used interchangeably with cost basis and adjusted basis. There are slight differences between each, though the general idea remains the same.

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What Is Included In the Tax Basis?

What is included in your tax basis is determined by how you received the asset. Let’s use stocks as an example asset.

As mentioned previously, the tax basis of stocks you purchase is determined as the purchase price plus additional costs to obtain the stocks. Let’s say you purchase 100 shares of a stock at $30 per share, and your commission is $90. Your total cost is $3,090. The tax basis of each share is $103.

If you receive the asset as a gift and sell it for a profit, you will use the same basis as the previous owner. However, for a gifted asset sold for a loss, the tax system prevents you from writing off a loss that happened while the previous owner still had the securities. In this case, you’ll use the lower of either the value of the stock at the time of transfer or the previous owner’s basis.

There are also other special rules for determining tax basis if you receive the asset through a divorce, stock splits, or other special circumstances.

Sometimes, you may convert an item from personal use to business use. In this case, you’ll need to use the adjusted basis or the fair market value on the date of conversion, whichever is lower.

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Adjustments

As we mentioned, the tax basis is sometimes also called the adjusted basis. This is because, in some circumstances, you need to adjust the basis due to certain events during ownership. These events may either increase or decrease your basis. 

If you make improvements that increase the asset’s value, you must increase your basis accordingly. However, if the property decreases in value, for instance, due to insurance reimbursements for theft or casualty losses, or allowable appreciation, you must decrease it.

Related: How R&D Credits Help With Payroll Taxes [2023]

Relationship with Depreciation

While the average person may deal with tax basis in the form of buying and selling securities, small businesses often need to determine the tax basis as it relates to durable physical assets. 

An asset that lasts more than one year is assigned a life span, usually called its tax life. Each year during the item’s tax life, you can deduct a certain portion of the initial investment through the depreciation allowance. What’s left of the unrecovered investment is the asset’s adjusted basis.

If you sell the asset before the end of its tax life, you’ll need to subtract the adjusted basis from the purchase price. You will need to pay income tax on this portion. If you sell the asset for more than what you originally paid, you will be taxed at the capital gain rate for the amount above the original purchase price.

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Making the Most of Your Tax Situation

It is critical to accurately determine your tax basis to make sure you get the most accurate numbers when tax time rolls around. To do this, you need to track your tax basis and anything that may adjust it later.

For securities, many brokerage services offer tools and reports that automatically track your basis for you. However, it will be up to you to keep track of many other assets. 

Luckily, even simple notes can help you. If you receive or purchase an asset, mark down how much it costs. If you make improvements or other changes that could affect the value, keep records about it. 

You’ll also want to calculate to determine how you should treat certain assets. For example, if you purchase a new piece of equipment, you can use Section 179 to immediately deduct the expense in the year of purchase. You also need to put the equipment into service this same year.

This deduction provides immediate tax relief, as you can deduct up to $1,080,000 in 2022. This can make it much easier to grow your business as you can get the equipment you need. However, you could also elect to spread the deductions over many years; the choice will depend on your specific situation. But analyzing how your tax basis could change can help you make a better choice.

As of 2022, the IRS introduced new rules regarding the deductibility of R&D costs. If your business does research and development activities, the updated Section 174 rules may get a little confusing. One of the biggest questions is whether a certain expense falls under this category or not. This could affect whether you sell the item in the future. If you are purchasing an asset, it can be helpful to discuss how the purchase may affect your current and future tax situation.

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Understand the Tax Basis of Your Assets

Tax basis is simultaneously confusing and seemingly simple at the surface level. However, it can get quite complicated depending on the situation. Make sure to understand the basics of tax basis and how it affects your business. This can help you make better financial decisions for your business.

Related: IRC Section 174: Get Lower Tax Bill For Inventors

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