By: Tom Nowak, CPA, Principal

In the accounting and financial world, the term “basis” is common and understood. The problem is that outside of the tax and financial environment, it is commonly misunderstood. And it is there, where it needs to be better understood and maintained by and for all taxpayers.

Basis is important information for any assets owned that may create income tax consequences upon liquidation. Whether you as the taxpayer understand and maintain basis or engage a professional to do such for you – the importance is that it is recorded and tracked to ensure proper tax treatment and potential financial analysis at liquidation (for example, a sale).

It is imperative to understand basis and the importance of recording and tracking it related to tax assets.

To assist in the recognition and tracking of basis in asset holdings, below are various examples of how basis is calculated, and records are maintained for different types of assets owned.

Tax Basis

You are not required to track basis in assets if there is not an expectation that you may sell or otherwise liquidate them in a taxable transaction. For example, personal assets like clothes, a tennis racquet, or golf clubs are assets you own, . but you most likely will never sell them as part of an income-producing transaction, so there is no need to track basis.

However, for income-producing assets that are required to be reported for income tax purposes (or if you want to analyze for financial analysis purposes) you must maintain and track basis. Examples of such assets are investments in stocks, non-term income-producing life insurance, Roth retirement accounts, and most other financial instruments. These could also include your residence, rental properties, and other real estate investments; investments in Partnerships and S-Corporations (“flow-through entities”);  – generally, any income-producing or investment-driven assets.

In simple terms, basis can be equal to an asset’s acquisition cost. However, it is important to note that basis in certain assets can change from acquisition cost, based on the complexity of the asset and income/deduction factors that may increase or decrease that original/acquisition cost basis that can occur annually and over time.

Example: You invest in shares of stock for $100. No activity occurs related to that stock to change the basis. Subsequently, you sell the stock for $250. Since your basis/cost would be $100 and you sold it for $250 you would have a gain of $150. Since the investment in stock is a taxable transaction, you would need to know that basis to correctly report the gain of $150 on your tax return.

How can the simple example above change where basis changes as the asset is held over time?

For example, you invest in the same stock for $100 but hold it for many years before selling it. During the time you held the stock, dividends were paid which were re-invested and a stock split occurred. The circumstance of the dividends used for additional investment would increase your stock basis and a stock split may also change your basis per share for tracking purposes. These types of changes to the investment require annual basis updates and monitoring of your asset holdings. If you utilize a financial advisor, consult with them on cost and basis tracking, as it is common for many brokerage firms and advisors to maintain stock basis records for you.

Common Types of Basis

Stock, Bond, and Mutual Fund basis for purchased investments are likely the most common assets requiring maintenance of basis, – but there are several other commonly-held assets for which basis is important.

Life Insurance Basis

Life insurance may require that basis be tracked. Term life insurance generally does not have asset value until a death benefit is paid and that is typically not taxable. However, whole life policies that have asset and cash surrender value do accumulate value and have basis that should be tracked. If a whole life policy is cashed in or liquidated for cash surrender value, the taxable portion is calculated by proceeds received less basis paid for the insurance.

IRA and Retirement Fund Basis

Retirement fund assets generally are funded with non-taxable contributions and, therefore, the distributions are taxable when made. But some retirement accounts (if funded with after-tax dollars) do require basis to be tracked to determine the appropriate taxable amount when distributed. IRS Form 8606 is commonly utilized to track basis in IRAs and retirement accounts. Children education funding accounts and 529 Plans also should have basis tracked over time. If the educational funds invested end up not being utilized in the appropriate tax-free manner, the taxable liquidation of those funds would have a basis factor to account in determining the appropriate taxable portion of the withdrawal transaction.

Investment in Partnerships and S-Corporations Basis

Basis has been required to be tracked for many years related to investments in Partnerships and S-Corporations. Taxpayers with these types of assets typically receive an annual K-1 Form reporting their share of income and deductions. That annual activity changes the owner’s basis. Income/capital contributions increase basis, and deductions/distributions decrease basis. In 2020, tax basis presentation for Partnership interests became a tax regulatory requirement. We advise consulting the tax preparer of these investments or your personal return preparer for assistance in maintaining basis in Partnership and S-Corporation investment assets.

Real Estate Basis

Basis in real estate can also change over time. Real estate basis begins with original cost paid for the investment (including closing costs).  Then, basis will increase and/or decrease over time. Basis will increase as a result of improvements made to the property. Basis will decrease as a result of depreciation, losses, and partial sales. Thus, ensuring to account for substantial improvements and these factors that decrease basis by adjusting basis upon such events is imperative to accumulate accurate basis reporting and, consequently, proper gain recognition when selling a portion of or a complete sale of a real estate interest. We recommend, when purchasing real estate, a proper allocation of cost between the land and depreciable assets should always occur at purchase. Land is not depreciated. Buildings and leasehold improvements are depreciated per tax regulation-prescribed useful lives and the depreciation taken annually reduces basis.

Tangible Personal Property Owned for Income Production

Tangible personal property is also depreciated annually per tax regulation-prescribed useful lives and the resulting depreciation expense reduces the basis in the corresponding asset(s). The difference is commonly referred to as Net Realizable Value. Beginning basis in tangible personal property is typically acquisition cost but can increase for additional costs incurred to place the property fully into service.

We encourage the periodic review of depreciation schedules for proper capitalization of additions and removal of disposed or abandoned tangible personal property. We also encourage taxpayers and their professional service providers cooperatively work together to maintain asset basis and depreciation records for optimal tax planning, and proper presentation of financial and tax information. Ultimately, accurate Personal Financial Statements and Business Financial Statements greatly assist in tax, financial and estate planning. Please contact your local Blue & Co Advisor with any question.