Original basis

What Is Original Basis?

Original basis, in the context of taxation and finance, refers to the initial value of an asset for tax purposes. This fundamental concept within taxation serves as the starting point for calculating capital gains or losses when an asset is eventually sold or disposed of. It generally reflects the cost incurred to acquire the asset, including not only the purchase price but also certain expenses related to the acquisition. The accurate determination of original basis is crucial for investors and individuals to properly report taxable events and manage their financial liabilities.

History and Origin

The concept of basis, and by extension, original basis, is deeply intertwined with the history of income taxation. While various forms of taxation have existed throughout history, the modern federal income tax in the United States, which necessitates the calculation of gains and losses, was established with the ratification of the 16th Amendment in 1913.¹⁹,¹⁸ Prior to this, the U.S. had imposed income taxes during the Civil War, but these were later repealed.

The need to precisely define the "cost" of an asset for tax purposes became paramount as the income tax system evolved. Early tax laws laid the groundwork for how initial investment in property would be treated, leading to the development of detailed guidelines on what constitutes original basis. The Internal Revenue Service (IRS) provides comprehensive guidance on this topic through publications such as IRS Publication 551, "Basis of Assets".¹⁷,¹⁶ This publication outlines how to determine an asset's basis at acquisition and how it can be modified over time.¹⁵

Key Takeaways

• Original basis is the initial value of an asset for tax purposes.
• It typically includes the purchase price plus acquisition costs.
• Accurate tracking of original basis is essential for calculating capital gains or losses.
• The method of acquisition (e.g., purchase, gift, inheritance) influences the determination of original basis.
• The original basis can be adjusted over time to become the adjusted basis.

Formula and Calculation

The calculation of original basis is generally straightforward for purchased assets. The basic formula is:

$\text{Original Basis} = \text{Purchase Price} + \text{Acquisition Expenses}$

Where:

• Purchase Price: The amount paid to acquire the asset.
• Acquisition Expenses: Additional costs directly related to acquiring the asset. These can include sales taxes, freight charges, installation fees, and legal fees for real estate.¹⁴

For example, if an investor buys shares of a company, the original basis would include the price per share multiplied by the number of shares, plus any brokerage commissions paid.

Interpreting the Original Basis

Understanding the original basis is critical for several financial calculations, particularly within tax planning. It forms the foundation for determining the taxable gain or deductible loss when an asset is sold. A higher original basis generally leads to a lower taxable gain or a larger deductible loss, while a lower original basis results in a higher taxable gain or a smaller deductible loss.

For instance, if an asset is sold for more than its original basis, the difference is a capital gain. Conversely, if it's sold for less, it results in a capital loss. This distinction directly impacts an individual's tax liability. Without an accurate original basis, it is impossible to correctly report these figures to tax authorities.

Hypothetical Example

Consider Sarah, who decides to invest in a piece of commercial real estate. She purchases a small office building for $500,000. In addition to the purchase price, she incurs the following costs:

• Legal fees: $5,000
• Recording fees: $1,500
• Title insurance: $2,000
• Property survey: $1,000

To determine the original basis of her office building, Sarah would add these acquisition expenses to the purchase price:

Original Basis = $500,000 (Purchase Price) + $5,000 (Legal Fees) + $1,500 (Recording Fees) + $2,000 (Title Insurance) + $1,000 (Property Survey)

Original Basis = $509,500

This $509,500 represents Sarah's initial investment in the property for tax purposes. If she later sells the building, this original basis will be used to calculate her taxable gain or loss, potentially after adjustments for depreciation or capital improvements.

Practical Applications

Original basis has wide-ranging practical applications in personal finance, investing, and business.

• Investment Portfolio Management: Investors must track the original basis of each security in their investment portfolio to accurately calculate gains and losses upon sale. This is especially important for tax harvesting strategies. The IRS generally requires the first-in, first-out (FIFO) method for identifying securities sold if specific identification is not possible.
• Real Estate: For real property, the original basis includes the purchase price and various closing costs. This figure is crucial for determining the gain when a property is sold and for calculating depreciation deductions if the property is used for business or rental purposes.
• Inherited and Gifted Property: The determination of original basis differs significantly for assets acquired through inheritance or as a gift. Inherited property often receives a "stepped-up basis," meaning the original basis is the fair market value of the property at the decedent's death.¹³,¹² This can significantly reduce potential capital gains tax for beneficiaries.¹¹,¹⁰ Conversely, property received as a gift generally retains the donor's original basis, meaning the recipient takes on the donor's historical cost.⁹
• Business Assets: Businesses use original basis to calculate depreciation expenses for assets like machinery, equipment, and buildings, which impacts their taxable income.

Limitations and Criticisms

While original basis is a fundamental concept, its application can present complexities and has faced some criticisms, particularly concerning inherited assets.

One key challenge lies in accurately determining the original basis, especially for assets held for a long time where records may be incomplete or for those acquired through non-standard means. The onus of accurate cost basis reporting often falls on individual investors.

The "stepped-up basis" rule for inherited property is a frequent point of discussion. While it can provide significant tax benefits to heirs by resetting the basis to the fair market value at the time of death, effectively eliminating capital gains that accrued during the deceased's lifetime, some critics argue that it allows for certain wealth transfers to escape taxation.⁸,⁷ This rule can also create complexities in valuation if a formal appraisal was not conducted at the time of death.

Another limitation arises with wash sales, where the IRS rules impact the original basis of repurchased securities, preventing investors from immediately claiming a loss if they buy substantially identical stock or securities within 30 days before or after the sale. Such regulations add layers of complexity to basis calculations.

Original Basis vs. Adjusted Basis

Original basis and adjusted basis are closely related but distinct concepts in finance and taxation.

The original basis sets the foundation, but it is the adjusted basis that is ultimately used to determine the taxable gain or loss when an asset is sold. For example, if an investor buys a stock (establishing an original basis) and later incurs fees for dividend reinvestment, these fees could adjust the basis. Similarly, for real estate, the original basis is increased by the cost of capital improvements, such as adding a new room, and decreased by deductions like depreciation. This modification from original basis to adjusted basis is crucial for accurate financial reporting.

FAQs

Q: Why is original basis important?
A: Original basis is important because it is the fundamental starting point for calculating capital gains or losses when an asset is sold. It directly impacts the amount of tax owed or the loss that can be deducted.

Q: Does original basis apply to all assets?
A: Yes, the concept of basis, including original basis, applies to virtually all types of assets, including stocks, bonds, real estate, and business property, for tax purposes.

Q: How do I find the original basis if I've lost my records?
A: If records are lost, taxpayers may need to reconstruct the original basis using various methods, such as bank statements, closing documents, historical market data, or by consulting with financial professionals. For publicly traded securities, brokerage firms often track this information, though investors may need to provide historical cost basis data for older holdings.,⁶

Q: Does receiving a gift affect the original basis?
A: Yes, when you receive an asset as a gift, your original basis is generally the same as the donor's adjusted basis. This is known as a "carryover basis."⁵

Q: What is the difference between original basis and market value?
A: Original basis is the initial cost for tax purposes, while market value is the current price at which an asset could be bought or sold in the open market. Market value fluctuates, while original basis remains fixed (or changes to adjusted basis) unless the asset is inherited.

Q: How does the Bogleheads philosophy relate to original basis?
A: The Bogleheads investment philosophy, which emphasizes low-cost, diversified index funds, indirectly simplifies basis tracking for many investors. Since index funds typically involve fewer individual stock transactions, calculating and tracking the original basis of holdings like a total market index fund or an ETF can be less complex than managing a portfolio of individual stocks. However, investors still need to track the original basis of their fund shares to determine gains or losses upon sale, particularly for non-retirement accounts.⁴,³,²,¹