What Does Adjusted Basis Mean and How Is It Calculated?

When you own an asset like a home or stock, its value for tax purposes is not static. This value, known as “basis,” represents your investment. Initially, the basis is what you paid for the asset, but it is modified over time by certain events. The result is what the Internal Revenue Service (IRS) calls the “adjusted basis.”

Adjusted basis is used to calculate your profit or loss, known as a capital gain, when you sell an asset. The capital gain is the difference between the asset’s selling price and its adjusted basis. A lower adjusted basis can lead to a higher taxable gain, while a higher adjusted basis can reduce it.

Determining Your Initial Basis

Your initial basis is determined by how you acquired the asset. For a straightforward purchase, the initial basis is the asset’s cost. This includes the purchase price plus any associated costs of acquisition, such as sales tax, freight charges, and certain legal and recording fees. For example, if you buy a piece of equipment for $10,000 and pay $600 in sales tax and $400 for delivery and setup, your initial basis is $11,000.

When an asset is inherited, the heir receives what is known as a “stepped-up basis.” This means the heir’s initial basis is the fair market value (FMV) of the asset on the date of the original owner’s death. For instance, if your uncle bought stock for $5,000 and it was worth $50,000 on the day he passed away, your initial basis in that stock would be $50,000, not the original $5,000 cost.

When you receive an asset as a gift, the rules for determining your initial basis are unique. Your basis for calculating a future gain is the same as the donor’s adjusted basis at the time of the gift. However, your basis for calculating a future loss is the lesser of the donor’s adjusted basis or the asset’s FMV when you received it. This dual-basis rule means that if you sell the gifted asset for a price that falls between the donor’s adjusted basis and its FMV, you will not report any gain or loss.

Factors That Increase Basis

Certain expenditures can be added to your initial basis, increasing its value for tax purposes. These include:

• Capital improvements, which are expenses that add to the value of the property, prolong its useful life, or adapt it to new uses. For a home, this could be a new roof or a kitchen remodel, but not a simple repair like painting a room.
• Assessments for local improvements paid to a municipality. If your city installs new sidewalks or sewer lines and assesses you for a portion of the cost, that payment is added to your property’s basis.
• Reinvested dividends for stocks and mutual funds. When you use dividends to purchase more shares instead of taking the cash, your basis increases by the amount of the reinvested dividends.
• Legal fees related to acquiring or defending the title to a property.

Factors That Decrease Basis

Just as some events increase your basis, others decrease it. The most common factors that reduce basis include:

• Depreciation, which is an annual tax deduction that allows you to recover the cost of property used for business or to produce income. You can claim depreciation on a rental property or business equipment, but not on your personal residence.
• Casualty and theft losses. If your property is damaged or stolen, you must reduce your basis by the amount of any insurance reimbursement you receive and by any deductible loss you claim on your tax return.
• Certain tax credits. If you install energy-efficient equipment in your home and claim a federal tax credit, you may have to reduce your basis in the home by the amount of the credit.
• Nontaxable corporate distributions, often called a return of capital. This is a return of your own investment that lowers your basis in the stock and is not taxed immediately.

Calculating Gain or Loss on a Sale

When you sell an asset, you must calculate your capital gain or loss. The formula is the amount you realize from the sale minus your adjusted basis. The “amount realized” is the selling price less any selling expenses, such as real estate commissions, advertising fees, and legal fees.

To illustrate, imagine you purchased a rental property for an initial basis of $250,000. During your ownership, you spent $30,000 on a major kitchen renovation, which is a capital improvement that increases your basis. Over the same period, you claimed $60,000 in depreciation deductions, which decreases your basis. Your adjusted basis is therefore $220,000 ($250,000 + $30,000 – $60,000).

If you then sell the property for $400,000 and incur $20,000 in selling expenses, your amount realized is $380,000. Your taxable capital gain is calculated by subtracting your adjusted basis from the amount realized. In this case, your gain would be $160,000 ($380,000 – $220,000). This is the amount you would report to the IRS and on which you would owe capital gains tax.