"Tax basis" is one factor used to determine the income tax consequences when an item is disposed of, whether by sale, abandonment, or contribution. An adjustments in basis may either increase or decrease the taxpayer's basis in the property. Here are 3 tips for understanding "basis."
Tip #1 - What is "Basis"?
The "basis"of an asset is what a person has paid for an asset together with money invested in an asset after purchase. This determines gain/loss for income tax purposes.
Example: You purchased your house for $100,000, but have since had to put on a new roof for $3,000, you added on a garage for $10,000, and updated the windows for $4,000. Your new basis in your house is now $117,000 ($100,000 + $3,000 + $10,000 + $4,000).
Tip #2 - What is "Stepped-Up" Basis?
A "stepped-up basis" occurs when assets get a new basis when they are passed by inheritance (through will or trust). These assets will be re-valued as of the date of death of the owner.
If the value of the asset has gone up in value since purchase, the new owner will take that asset with a new basis equal to the current value without paying tax on that increase. This has the potential to save a significant amount of capital gains upon sale in the future and can be a good way to do some strategic estate planning.
Example: My mom bought real estate in 1950 for $25,000. When she died last year it was appraised at $500,000. I received that real estate from her estate and my basis is now $500,000 tax-free. If my mom had sold this real estate before she died she would have had to pay taxes on $425,000 of gain, but because she died with the property I received a "step-up" in basis to the current value.
Tip #3 - What is "Stepped-Down" Basis?
A "stepped-down" basis is the same as the "stepped-up" basis - except the asset has gone down in value since it was purchased. The new owner would take that asset with a new lower (stepped-down) basis. This depends on the value as of the date-of-death of the owner compared to the price the owner originally purchased the asset.
Example: Dad was convinced that AOL was going to make a comeback. He bought it for $50,000 and it’s now worth $10,000. Instead of selling his AOL stock at a loss during his lifetime he held onto it. I now own it with a basis of $10,000.
So as you can see, understanding an asset's "basis" is a great way to decrease your tax bill!