Accounting terms can be confusing, especially when they’re unfamiliar. “Unadjusted Basis” is one of those terms. Investors frequently hear the term “cost basis,” which is essentially the same concept, but rarely see it referred to as adjusted or unadjusted. Their comparative variable is typically “fair market value.” This article will explain what these terms mean. Some key takeaways:
- Asset basis refers to the amount paid or the current equity owned in a property or other asset. Stock market investors refer to this as the cost basis.
- Unadjusted asset basis is a fixed variable used to report gains or losses on an asset and is the starting point for return calculations.
- Adjusted basis is the value of an asset after improvements, depreciation, and other adjustments. It’s used to calculate tax liability.
What is asset basis?
Asset basis is the amount paid or the current value of your investment in a property or other asset. For example, if you bought a house for $500K, your asset basis at the time of purchase equals $500K. This differs from market value, which is the price someone is willing to pay for that house, and the fair market value that an assessor sets.
There are two types of asset basis.
Unadjusted basis is the starting point. It tells you how much you initially paid for the investment. You may hear it referred to as cost basis.
Adjusted asset basis is what your investment is worth after calculating depreciation, amortization, and depletion deductions.
Both are important in tax preparation.
Let’s begin with the unadjusted cost basis.
The unadjusted basis of an asset includes the purchase price, sales tax, delivery fees, installation costs, setup, and testing expenses. It’s called the “cost basis” because it includes all the costs associated with acquiring the asset. Inherited property is assigned an unadjusted basis slightly higher than the fair market value.
Stock market investors, for example, are provided a cost basis when they purchase a security or other financial product. In real estate, it’s generally referred to as the unadjusted basis of the investment.
Here’s why unadjusted cost basis is a fixed variable when we calculate returns.
Gains and losses are determined by comparing the current asset basis with the unadjusted basis. The latter never changes, so it’s a fixed variable in return calculations.
Unadjusted cost basis is directly related to realized gains and income tax.
Realized gains count as income. That means you’ll pay capital gains taxes on whatever you make over the unadjusted basis when you sell the asset. The same rule applies to losses. If you buy a property that depreciates while you own it, that counts as a loss. Your accountant can use that to reduce your taxable income, thus minimizing your tax liability.
Assets appreciate and depreciate over time. That’s where adjusted basis comes into play.
Adjusted basis is the updated asset value after improvements, depreciation, and other adjustments; this number constantly changes, so your net worth is never fixed. A glance at your 401(k) or IRA will provide evidence of this. An assessment of your property will reinforce that.
Adjusted basis influences tax decisions and affects decisions on high-value assets, such as real estate.
The importance of an adjusted basis cannot be overstated when the time comes to pay your taxes. A higher basis on real estate could justify a higher sales price. Selling equity that’s increased in value creates a realized gain. These actions lead to tax liabilities that could significantly reduce your profits on an asset sale.
Now that we have our definitions, let’s take a look at some examples.
Real Estate
Unadjusted basis: You purchase a commercial office building for $500,000.
- You add a new roof for $25,000.
- Renovation costs total $50,000.
- A storm floods your basement. Insurance payment is $10,000
Adjusted basis: The roof and kitchen remodels increase the property’s value. Insurance damage is deducted from it. That means the adjusted asset basis is $500,000 + ($25,000 + $50,000) – ($10,000) = $565,000. That’s a $65,000 gain if you sell the property today.
Business Equipment
Unadjusted basis: Your company purchases a machine for $75,000
- Original purchase: $75,000
- Installation: $5,000
- Upgrades: $15,000
- 5-Year Depreciation: $64,000
Adjusted basis: In this case, the purchase price, installation, and upgrade are positive. Depreciation is negative: ($75,000 + $5,000 + $15,000) – ($64,000) = $31,000. This adjusted basis determines your gain or loss upon disposal and affects future depreciation calculations.
Investments and Securities
Unadjusted basis (cost basis): You buy 100 shares of stock for $10,000
- You reinvest your dividends and buy 20 more shares: $2,000
- The stock splits 2-for-1, and you now own 240 shares
Adjusted basis: Your $10,000 investment is now worth $12,000, and you own 240 shares. You initially paid $100 a share, but the split resets the cost basis to $50 a share. Without tracking these adjustments, you might significantly miscalculate capital gains when selling.
A CPA firm should understand and leverage the tax implications of cost-basis calculations.
The difference between what you pay for an asset and what you sell it for is either a taxable gain or a deductible loss. A good accountant can help you minimize liabilities and maximize profits. Here are some of the tax implications we look for:
- Capital Gains Tax: There are several variables in calculating capital gains taxes, including how long you owned the asset, the original purchase price, and your taxable income at the time of the sale.
- Depreciation Deductions: As illustrated above, depreciation is deducted from the asset basis. Recently, the OBBA introduced 100% bonus depreciation, and assets like real estate and equipment are eligible.
- Qualified Business Income Deduction: Under Section 199A, the unadjusted basis of qualified property affects the deduction limit for pass-through entities. This is relevant to LLCs, LLPs, and S-Corps that have investment portfolios or real estate holdings.
- Estate Planning: An inherited property is given an unadjusted asset basis that is typically higher than fair market value. That could eliminate capital gains tax on the appreciation if you sell the property immediately.
Professional guidance makes a difference.
Tax regulations and limits on deductible expenses are subject to frequent changes. Understanding the difference between unadjusted and adjusted asset basis is important for investors, business owners, and property owners.
Schedule a discovery call today to get your tax strategy squared away.
Talk soon,
Jeremy A. Johnson, CPA