All your basis are belong to IRS!
In an attempt to catch me up in the ongoing video game revolution that I have mostly missed, my husband has educated me about certain gamer-generated memes that have reached iconic status. One such is the phrase “All your base ‘are belong’ to us”, from the overly literal translation from Japanese to English of the opening credits of the 1989 arcade game Zero Wing, published by Taito. If, like me, you missed this gem and want to appreciate the context, you can listen to the full piece of curious dialogue here. While I more or less grasp the intent of the phrase, I’m not quite to the point where I understand exactly how to apply it in daily life, making this meme a bit akin to professional jargon. Unless you come from a context of frequent use, understanding its meaning may require some tuition. We’re going to examine one such word here. Basis.
I explained last week how, although tax filing season doesn’t start till sometime in January of next year, my brain, as a part-time preparer, is already in tax analysis mode. I am still helping my clients understand the implications of the Tax Cuts and Jobs Act (TCJA), which went into effect, last season. My last blog discussed how to analyze your withholding situation in order to make sure that you are paying sufficient income tax on an ongoing basis to avoid a big bill and possible penalties at filing time. In addition, it is part of my role as both a financial planner and a tax professional to help clients prepare well in advance for the tax implications of financial transactions that, unlike the receipt of a paycheck, do NOT occur regularly and may require more complex calculations.
For example, my husband and I sold a condo this year. The condo had been our primary dwelling for some years. We converted it to a rental in 2011, when we purchased a house. The IRS is going to want to know whether this sale resulted in a gain or a loss for us, because if it was a gain, the IRS is going to want to collect their share of that income. When most of us consider whether we sold something at a gain or a loss, we simply compare the sales proceeds that we receive to the amount we originally paid for the item. If I buy a car for $25,000 and seven years later sell it for $9,000, it seems to me that I sold it at a loss. If I buy my house for $250,000 and sell it 10 years later for $370,000, then it seems to me that I have a gain. But if the real estate market is weak and I can only sell it for $220,000, then I have a loss.
The IRS, however, takes a different approach. Instead of comparing the resale price for your item to the original purchase price, the IRS compares the resale price to what is called your “basis” or sometimes, your “adjusted basis”. Your basis in an asset is its original purchase price, adjusted up or down for certain reasons that the IRS believes have increased or decreased its value. Some adjustments to basis are very straightforward and obvious. Real estate provides a good example of this kind of obvious adjustment. If I buy my house for $250,000 and then spend $10,000 to put on a new roof and then $40,000 to put on an addition, it makes sense that my house is now worth more than the original purchase prices of $250,000. If, after these expenditures, I were to turn around and sell my house for $300,000 it would be unreasonable to compare my sale price to my purchase prices for the purpose of determining whether I had a gain on the sale because that calculation does not take into account the fact that I spent $50,000 to improve the property between the time of my purchase and the time of my resale. In fact, the IRS agrees. The basis of my home at the time of sale is the $250,000 I paid for it originally, plus the $50,000 of improvements or $300,000.
Let us suppose now that my house, which I bought for $250,000, was in a hurricane zone and sustained $50,000 worth of damage in a storm. That reduces my basis in my home by $50,000. If, however, I receive insurance proceeds to repair my home, those proceeds would again increase my basis. If my insurance company covered exactly $50,000, then my basis would be back where it started. If it covered only $40,000, then my basis would have decreased by $10,000. Note that I am allowed to take a casualty loss deduction (subject to certain limitations) on my taxes in the year I sustain this loss, or, in some cases, the year prior. This is important. Let’s say I use my $10,000 plus the insurance company’s $40,000 to restore my home to its pre-disaster condition. But I no longer want to live in an area so much at risk from hurricanes. I sell my property for $250,000, but since my basis is only $240,000, I would have a gain of $10,000. The taxes that I would might owe on that $10,000 would have been offset by the casualty loss I took previously. Note also, that there although there may be a gain on the sale of a personal residence when the re-sale price exceeds the basis, that gain may be exempt from taxes depending on how long the seller has lived in the dwelling. But that is a separate discussion.
The case of my condo was a little more complicated. Since it was converted from a personal residence to a rental property, I was selling it as a “business asset”. Unlike personal-use assets, such as my home that I live in or my car that I drive solely for my own use, business assets such as my rental property or the truck that someone might use for her/his delivery business, can be depreciated. Depreciation is method of accounting for the fact that although an asset might generate income, there was also an expense associated with acquiring the asset in the first place and the IRS should only tax the difference between the income and the corresponding expense. Generally, the cost of an asset with long-term income-generating potential is expensed gradually over the useful life of that asset. That is, the asset is depreciated. Since depreciation is an expense that reduces taxable income, this tax benefit must be reconciled if/when you sell the asset and report a taxable gain or a deductible loss.
If you put the asset to business use immediately, the basis for depreciation is the purchase price plus any installation costs. If you convert an asset from personal to business use, as I did, the basis for depreciation is the lower of the purchase price plus any adjustment OR the fair-market value at the time of conversion. In the case of my condo, the market had dropped between the time I bought it and the time I began to rent it—that was the whole reason I rented instead of selling immediately. So my basis for depreciating the condo as a rental property was the lower fair market value in 2011.
Now that I have sold it, the question of applicable basis becomes even MORE complicated. If I had sold it for more than I bought it for originally—and hence at what both the IRS and the average person-on-the-street would agree is a “gain”, then my basis for calculating the gain on which I will pay taxes should be the original purchase price (always adjusted for any improvements or casualty losses) adjusted for the depreciation for which I already got credit. BUT if the price at which I have sold the unit is lower than that original-purchase-price-determined basis—which would result in what both the IRS and the average person would agree is a “loss”, THEN I should calculate my loss using as a basis the fair-market value at the time of conversion less the depreciation I already took. In my case, the purchase price for the condo was $146,000. The fair market value at the time of conversion was $90,000, the accumulated depreciation at the time of resale was $26,000 and the resale price came in at $109,000. Using the original sales price, I would have no gain because $146,000 (the purchase price) - $26,000 (depreciation) = $120,000 (the basis for calculating a gain) and $109,000 (the resale price) - $120,000 (the basis for calculating a gain) = an $11,000 loss. But, using the fair market value as the basis, I would have no loss because $90,000 (the fair market value at the time of conversion) - $26,000 (depreciation) = $64,000 (the basis for calculating a loss) and $109,000 - $64,000 = a $45,000 gain. Because my resale price falls below the basis for calculating gain and above the basis for calculating loss, I have neither.
All this might leave you as, if not more, confused than the Japanese to English translator for Zero Wing. It’s our job as financial and tax professionals to unscramble the jargon and make sense of its application. All your basis “are belong” to the IRS, but we will make sure you don’t pay a cent more in tax than you have to.