What Is Substituted Basis for Tax Purposes?

An asset’s tax basis is its value for tax purposes, used to calculate gain or loss on a future sale. While this is often the original cost, a substituted basis applies when property is acquired through means other than a direct purchase, such as a gift or a specific type of exchange. A substituted basis is determined by referencing the basis of another property or person, ensuring any deferred gain or loss is preserved for a later taxable event.

Substituted Basis in Gift Transactions

When you receive property as a gift, your basis is the same as the donor’s adjusted basis at the time of the gift. This is referred to as a “carryover basis” under Section 1015 of the Internal Revenue Code and prevents gains from escaping taxation through property transfers. For example, if you receive stock as a gift that the donor purchased for $1,000, your initial basis is also $1,000.

Your basis may be increased by any gift tax the donor paid. The basis is increased by the portion of the gift tax paid that is attributable to the net appreciation in the value of the gift. Net appreciation is the amount by which the fair market value (FMV) of the gift exceeds the donor’s adjusted basis. For instance, if a donor gives you property with an FMV of $150,000 and their basis was $100,000, the appreciation is $50,000, and any basis increase from gift tax paid would be calculated based on this amount.

If the property’s FMV is less than the donor’s adjusted basis at the time of the gift, a “dual-basis” rule applies. Your basis for determining a future gain is the donor’s higher adjusted basis, but your basis for determining a future loss is the lower FMV. If you sell the property for a price between the donor’s basis and the FMV, you recognize neither a gain nor a loss. For example, if the donor’s basis was $10,000 and the FMV was $8,000, selling it for $12,000 means you use the $10,000 basis for a $2,000 gain. If you sell it for $7,000, you use the $8,000 FMV for a $1,000 loss.

When you receive a gift, you also inherit the donor’s holding period for the asset in a process known as a “tacked” holding period. If the donor held the property for more than one year, you are also considered to have held it for that long. This is relevant for determining whether a future gain or loss is long-term or short-term.

Substituted Basis in Tax-Deferred Exchanges

Tax law allows for the exchange of property without immediately recognizing a gain or loss in certain transactions. The most common example is a like-kind exchange of real estate, governed by Section 1031 of the Internal Revenue Code. In these exchanges, the basis of the new property you receive is determined by the basis of the old property you gave up.

The new property’s basis is calculated by starting with the adjusted basis of the property you relinquished. This amount is then increased by any cash or other non-like-kind property, known as “boot,” that you gave up, and by any gain you recognized on the exchange. The result is then decreased by any cash or boot you received.

Consider an investor who exchanges a building with an adjusted basis of $300,000 for a new building and also pays $50,000 in cash. The basis of the new building would be the $300,000 basis of the old property plus the $50,000 cash paid, resulting in a substituted basis of $350,000.

These exchanges are tax-deferred, not tax-free, meaning the unrecognized gain is built into the new property’s basis. To qualify, strict rules must be followed. This includes using a qualified intermediary and meeting specific deadlines for identifying and receiving the replacement property.

Substituted Basis in Business Formations

The principle of substituted basis also applies when forming a business. When an individual contributes property to a corporation for stock or to a partnership for an interest, the transaction can often be structured to be tax-free under rules like Section 351 of the Internal Revenue Code. This allows business owners to transfer assets into an entity without triggering immediate tax.

In these formations, the basis of the stock or partnership interest received by the individual is the same as the basis of the property they contributed. For example, if an entrepreneur contributes equipment with an adjusted basis of $50,000 to a new corporation for all of its stock, their basis in that stock is $50,000.

If the individual contributes cash in addition to property, their basis in the stock or partnership interest is increased by the amount of cash. Conversely, if the newly formed business assumes any of the individual’s liabilities related to the contributed property, the individual’s basis in their new interest is reduced by the amount of those liabilities.

Adjustments to Substituted Basis

Once an initial substituted basis is established, it is not a static figure. Throughout the life of an asset, various events can require you to adjust its basis under Section 1016 of the Internal Revenue Code. Tracking these adjustments is necessary for accurately calculating depreciation and the gain or loss upon disposition.

Certain events will increase your basis in the property, which are capital expenditures that add to the asset’s value or prolong its useful life. Examples that increase basis include:

• The cost of major additions or improvements
• Overhauling an engine in large machinery
• Legal fees associated with defending the title to the property
• Expenses related to zoning and assessments

Other events will decrease your basis. The most common adjustment that decreases basis is the annual deduction for depreciation, which must be subtracted from your basis each year it is claimed. Other basis-reducing events include receiving an insurance reimbursement for a casualty loss or the sale of an easement on the property.