When you start up a business and set up your accounting, what values do you assign to your assets? Or, when you acquire property by purchase, exchange, conversion, or other means, what value should be assigned to the property? The Internal Revenue Service provides some specific guidelines for determining the basis of assets for tax purposes.
Monetary and Non-monetary Items
Certain assets and liabilities have a clearly assigned monetary value. These would include cash, bank accounts, and loans payable. As you conduct your business, other items are determined as a specific monetary amount, such as accounts receivable from customers and clients, and accounts payable to suppliers. These monetary values are supported by documentation, such as invoices you issue to customers or clients, invoices you receive from suppliers, and loan documents with banks or other lenders. Other assets, such as inventory and fixed assets may not have a readily determinable monetary value. This may depend on how you acquire the assets.
Historical Cost
A basic accounting principle is that the value assigned to assets is normally their historical cost. When you purchase something for use in your business, the amount you pay is normally the value assigned for accounting purposes. For example, if you purchase property, plant, machinery, vehicles, office equipment, furniture or any other assets, whether new or used, the amount you actually pay is the historical cost of the asset, and is the amount that would be booked. This should include amounts paid in order to place the asset in service, such as delivery and installation charges. This is the basis that will be used to calculate depreciation on the asset, if applicable, and to determine your gain or loss if you subsequently sell or dispose of the asset.
Book and Tax Values
But there may be cases in which information on historical cost is not readily available. When you start a business, you may convert assets from personal use to business use. Or you may acquire assets in exchange for services, or in exchange for other assets. In these cases it may be necessary to assign a value. One possibility is the fair market value of the asset. But consideration should also be made of the criteria established by the Internal Revenue Service. U.S. federal income tax law establishes some specific criteria for determining the basis of assets for tax purposes. This basis may or may not be the same value as that assigned for book purposes.
Basis
The amount of your investment in property for tax purposes is called the basis of the property. This is the amount you use for calculating depreciation, amortization, depletion, and casualty losses. It is also the amount you use to calculate gain or loss on the sale, exchange or other disposition of the property for tax purposes. The U.S. federal income tax provisions refer to cost basis, adjusted basis, and basis other than cost.
When you purchase property, its basis is usually its cost, as it would be for book purposes. Certain costs related to the purchase may have to be capitalized (added to the basis). This amount then becomes your original basis in the property. Your original basis may subsequently be increased or decreased by certain events. For example, if you make improvements to the property, the basis may be increased. And if you take deductions for depreciation or casualty losses, the basis is decreased. Your adjusted basis in the property is your original basis, plus or minus the effect of these events. Basis other than cost applies for property received as a gift or inheritance, or through involuntary conversions and certain other circumstances.
Property You Purchase for Use in Your Business
The basis of property you purchase is its cost to you, including amounts you pay in money, debt you assume, and property or services you give in exchange. The cost also includes sales tax, freight, installation and testing, and excise taxes. If you purchase real property, the basis is increased for certain costs related to the purchase. These include closing costs and settlement fees, such as fees for an abstract of the title, legal fees for title search and preparation of the sales contract and deed, recording fees, surveys, transfer taxes, and owner’s title insurance. Any amounts that the seller did not pay and that you as the purchaser agree to pay, such as back taxes, interest, mortgage fees, charges for improvements or repairs, and sales commissions, also become part of your basis in the property. Points you pay to obtain a mortgage loan or other credit to purchase the property are not added to the basis, but rather, are amortized over the life of the loan. If you assume an existing mortgage on the property, your basis includes the amount you pay plus the balance due on the mortgage.
Property You Build
If you build property, or hire a contractor to build it for you, your basis in the property includes all costs related to the construction, including the cost of the land, architect’s fees, building permit charges, the cost of labor and materials, payments to contractors, payments for rental equipment, and inspection fees. If you use employees, materials and equipment from your business to build an asset, your basis will include wages paid to the employees for their work on the construction, business materials and supplies used in the construction, operating and maintenance costs on machinery and equipment, and depreciation on that equipment for the period it was used in the construction. If you are a sole proprietor and work on the construction yourself, or if other persons worked on the construction without pay, you cannot include the value of that labor in the basis.
Uniform Capitalization Rules
These are rules that define what costs must be capitalized for tax purposes in certain circumstances. If your business involves any of the following activities, you are subject to the uniform capitalization rules:
Producing real or tangible personal property for use in the business
Producing real or tangible personal property for sale to customers
Acquiring property for resale
Producing property has a broad definition for these purposes, and includes constructing or building property, as well as installing, manufacturing, developing, improving, creating, raising, and growing property. Tangible personal property includes physical goods or products and also includes intellectual works, such as films, recordings, video tapes, books, and similar property.
Under the uniform capitalization rules, you include in the property’s basis all the direct costs and an allocable portion of most indirect costs involved in your production or resale activities. Indirect costs include rent, interest, taxes, storage, purchasing, processing, repackaging, handling, and administrative costs. These capitalized costs are then recovered through depreciation or amortized as the property is used, or through cost of goods sold, when you sell the property.
Exceptions
The following types of property and expenses are not subject to the uniform capitalization rules:
Property you produce that is not used in your trade or business
Qualified creative expenses as a free-lance writer, photographer, or artist, which can be deducted as expenses on your tax return
Property you produce under a long-term contract
Research and experimental expenses allowable as a deduction
Costs of personal property acquired for resale if your average annual gross receipts for the three previous tax years do not exceed $10 million
Intangible Assets
Intangible assets include goodwill, patents, copyrights, trademarks, trade names, and franchises. Intangible assets also include your business start-up costs.
The basis of a patent is the cost of research and development expenditures (unless you choose to deduct them as expenses), drawings, working models, and attorneys’ fees and government charges for obtaining the patent.
The basis of a copyright generally includes copyright fees, attorneys’ fees, and clerical assistance. The value of your time as the writer or producer of the copyrighted material is generally not considered part of the basis.
The basis of trademarks, trade names, and franchises is the amount you paid for them. Goodwill is an intangible asset that represents the excess of the amount you paid over the book value of the assets or investment you acquired.
Business start-up costs include legal and tax consulting fees to set up the legal structure for your business and all other expenditures you incur prior to actually starting operations. Up to $5,000 of start-up costs paid or incurred after October 22, 2004 can be deducted as expenses for tax purposes, and the remainder can be amortized over a period of 180 months.
Group of Assets or Trade or Business Acquired
If you pay a lump sum for a group of assets, you need to allocate the purchase price among the assets to determine the basis of each. This could be done on a proportional basis, according to fair market values at the time of the purchase.
For tax purposes, when you acquire a trade or business you generally allocate the total consideration paid (including cash, the value of property and services you give, and any debt you assume) among the assets acquired. You do this by first reducing the total consideration you paid by the cash or bank accounts you received (which have a definite monetary value), and then allocating the remainder of the amount you paid to the other business assets you acquired , in proportion to the fair market value, in the following order:
Certificates of deposit, securities and other highly liquid assets
Accounts receivable and other debt instruments
Inventory
Fixed assets
Intangibles
Goodwill
The buyer and seller can enter into an agreement as to how the purchase price should be allocated among the assets, and this agreement will be binding unless the IRS determines otherwise.
Property Converted from Personal Use to Business Use
The basis of property that you convert from personal use to business use is the lesser of:
The fair market value of the property on the date you start using it for business purposes, or
Your adjusted basis in the property on the date you converted it to business use.
Adjusted Basis
Your adjusted basis in property is your original basis, which may be cost or some other basis, depending on how you acquired the property, plus or minus certain adjustments. The basis of property is increased for additions and capital improvements that have a useful life of more than one year. You should keep separate records of improvements, since you will have to depreciate them separately for tax purposes.
Some examples of items that increase the original basis include:
Capital improvements, such as putting an addition on your home, replacing the roof, and installing central air conditioning
Local assessments, such as sidewalks and roads
Cost of restoring property after a casualty loss
Legal fees for defending and perfecting a title
Zoning costs
Some examples of items that decrease the basis include:
Depreciation
Casualty or theft loss deductions and insurance reimbursements
Subsidies for energy conservation measures that are excluded from income
Tax credits for clean-fuel vehicles and qualified electric vehicles
Basis Other than Cost
There are several cases in which cost is not your basis in the property for tax purposes. The following are some examples of when a basis other than cost is assigned to the property.
Property Received for Services
If you receive property in payment for your services, you include the property’s fair market value in your income, and this becomes your basis in the property. If the value of the property was agreed on beforehand, you can use this as the property’s fair market value, unless there is evidence to the contrary.
Taxable Exchanges
In a taxable exchange, in which you are subject to tax on a gain and are allowed to take a deduction for a loss, the basis of the property you receive in the exchange is usually its fair market value at the time of the exchange. A taxable exchange occurs when property is exchanged for property that is not similar. This is differentiated from a like-kind exchange, which may not be taxable.
Involuntary Conversions
Involuntary conversions include casualties, thefts, and condemnations of property. If you receive similar property as a result of the involuntary conversion, the basis of the replacement property you receive is the basis of the old property on the date of the conversion plus or minus the following:
Decrease the basis by:
Any loss you recognize on the conversion (tax-deductible loss)
Any money you receive in reimbursement that you do not spend on replacement property
Increase the basis by:
Any gain you recognize on the conversion (taxable gain)
Any cost related to acquiring the replacement property
If as a result of the conversion, you receive money or other property that is not similar to the old property, and you buy replacement property, the basis of the replacement property is its cost reduced by any gain that you did not recognize on the conversion (gain that was not taxable).
Non-taxable Exchanges
In a non-taxable exchange, you do not have to pay tax on any gain, and you are not allowed to deduct a loss. A non-taxable exchange normally occurs when similar property is exchanged. This is commonly referred to as a like-kind exchange. In order to qualify as a non-taxable exchange, both the property you transfer and the property you receive must have been for business use. Any exchange expenses you have to pay, such as closing costs, are added to the basis of the property you receive.
If you trade property and also pay money in a like-kind exchange, the basis of the property you receive is the basis of the property you give up plus the money you pay, rather than the value of the replacement property. This would be the case when you trade in a used vehicle for a new one, for example.
Property Received as a Gift
If you receive property as a gift and use the property in your business, your basis for calculating depreciation or amortization is the donor’s adjusted basis in the property. If you subsequently sell or dispose of the property, for purposes of calculating any taxable gain or loss, you will need to know:
The fair market value of the property when you received it as a gift
The donor’s adjusted basis in the property
Any gift tax paid
Your basis in the property for purposes of calculating gain or loss on a subsequent sale or other disposal will depend on whether the fair market value of the property was more or less than the donor’s adjusted basis at the time of the gift, plus or minus any adjustments to that basis while you held the property (capital improvements, casualty loss, etc.). And, if the fair market value of the property was equal to or greater than the donor’s adjusted basis at the time of the gift, you will increase the basis by all or part of the gift tax, depending on whether the gift was made before or after December 31, 1976. This will only be a tax consideration if you subsequently sell or dispose of the property. For purposes of recording depreciation on the property, you would use the donor’s adjusted basis.
Inherited Property
If you inherit property, your basis is generally the fair market value of the property on the date of the person’s death, or on the alternate valuation date chosen by the personal representative for the estate. There is also a special-use valuation method for real property used in farming or a closely held business.
If a federal estate tax return does not have to be filed, your basis in the property is generally its appraised value at the date of death.