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Understanding Tax Basis

Posted Jul. 1, 2000

The importance of basis is best understood when it comes time to settle up with Uncle Sam each year. The basis one has in capital assets affects how much tax he or she will owe. Basis is the term the tax law uses to refer to the amount of investment a taxpayer has in business assets. The expense or investment in some business purchases such as feed, seed, and fertilizer can be deducted completely the year of purchase. The Internal Revenue Service (IRS) refers to this as expensing, which is allowed on these items because they do not have a useful life beyond one production season, unlike other items called capital assets, such as tractors, cows, and most machinery. The IRS requires businesses to capitalize the cost of these items.

Each item or asset has an assigned life, often referred to as tax life. During each year of the asset's tax life, you can deduct or recover a portion of the initial investment as a depreciation allowance. The remaining investment or unrecovered cost is the asset's adjusted basis. If an asset is sold before the end of its tax life, the difference between the purchase price and the adjusted basis is subject to income tax. If the asset is sold for more than its purchase price, the portion above the original purchase price will be taxed at the capital gain rate. The IRS adjusts the basis for depreciation allowable, even though it may never have been deducted.

There is a provision in the tax law that allows a taxpayer to expense an asset rather than treat it as a capital expenditure the year the asset is placed in service: a Section 179 Expense Election. The maximum Code Sec. 179 deduction is $19,000 for tax years beginning in 1999 and $20,000 for those beginning in 2000. For example, if you are a calendar year taxpayer, you could purchase a $30,000 tractor this year and expense or deduct $20,000 this year as a depreciation allowance. You could then deduct a portion of the remaining $10,000 each year throughout the tax life, leaving a zero basis in the tractor at the end of the tax life.

An item used solely for personal use may later be converted to business use for example, an automobile, refrigerator, lawn mower, or other asset adaptable to both personal and business use. The proper basis for depreciation in such a case is the fair market value on the date of conversion to business use or the adjusted basis, whichever is lower.

There are some interesting twists to the tax law concerning basis when it comes to receiving property by gift or by bequest or inheritance. If property is acquired by gift, the basis for depreciation is the donor's (the person making the gift), which passes to the donee (the person receiving the gift). If the property is later sold by the donee, the basis for determining gain on the sale of the property is the same as it would have been in the hands of the donor. On the other hand, if property is acquired by bequest or inheritance, the new owner uses the fair market value of the property at the death of the previous owner as the basis. If the property is later sold, there could be a significant difference in the amount of tax owed, depending on how the title to the property was received. An example may help to clarify the difference. Let's say a farmer gives his child a piece of land that cost $20,000 and is worth $50,000. If the child later sells the land for $50,000, he or she would have to pay tax on $30,000, the difference between what the father gave for the land ($20,000) and the selling price ($50,000). Now if the child inherited the land, the basis would be the fair market value at the time of the father's death. The child would receive what is referred to as a stepped-up basis in the land. Later, if the child sold the land for $50,000, there would be no tax due because the basis in the land was the same as the selling price. Land cannot be depreciated because it has no distinguishable lifeit is never considered used up, so the basis in the land stays the same.

I should mention that when land is transferred by will, there are probate costs that vary with the will's complexity and can often be avoided by using trusts.

Many things can complicate the simplicity of this example, such as mortgages assumed by the new owner and possibly probate procedures. In addition, the tax law has limits, exceptions, and certain quirks that are applicable. However, the principles discussed here are still relevant. It is advisable to seek the counsel of a professional competent in farm taxation or intergenerational transfer before making any decisions. As demonstrated here, though, there can be substantial tax savings with proper planning.