Small Business Taxes & Management^TM--Copyright 2026, A/N Group, Inc.

Introduction

Basis is a special tax term that's used to describe your "cost" in an asset. For example, you bought 100 shares of Madison Inc. for $55 a share and now you're selling it for $70. If there are no special issues your basis for gain (or loss) is $55. In many cases it's that simple--but not always. But before you decide to sell an asset for a substantial amount you should know your "adjusted basis" so you can calculate your gain and, ultimately, your tax liability. Adjusted basis is basis plus or minus certain items. In the case of equipment or real estate that will always be an adjustment for depreciation (except for land). We'll break the issue down into different situations to make it easier. Always keep in mind that virtually any tax issue can be more complicated than it seems and all the numbers we use in examples are for ease of calculation, not total accuracy (e.g., depreciation calculations are not necessairly accurate).

Principal Residence

This one is generally straightforward. You and your spouse purchased your home in 2015 for $300,000. At closing you also paid for title insurance, legal fees, title search, recording fees, a survey and transfer taxes. As part of the deal you agreed to pay the property taxes and homeowner's association fees the seller owed that occurred before the date of sale. All that adds up to $29,000 and is added to the purchase price of $300,000 to form your basis. In the 11 years you owned the house you added a bedroom for $35,000, central air for $8,000, and upgraded the electrical for $5,000. Your basis is $377,000.

If you used part of your residence for business or rented out part, you would have taken depreciation and that would reduce your basis. See "Business Equipment" below to see how depreciation can affect a sale of property.

If you deferred gain on a home that was sold using a pre-1997 rollover transaction your basis in your current home will be determined in part by your basis in the last home. For example, you paid $30,000 for the house in 1980. In 1990 you sold the home for $150,000 and bought a new home for $210,000. You would have deferred the gain. As a result your basis in that home is $30,000 plus the additional amount you paid for the new home, $60,000 or $90,000 (plus any additions such as closing costs, etc.). If you sold after May 6, 1997 you would have recognized any gain at the time of sale.

Sounds simple, but there are many more factors that can affect basis in a home. In fact, there are enough for a whole article.

Creating Basis and IRAs

You create basis when you purchase and asset--for cash, a note or mortgage, in exchange for another asset or for services rendered or make an "after tax" contribution. For example, Fred works at an auto repair shop. The owner is short of cash and gives Fred a used car the owner had on the market for $5,000. Fred's basis in the car would be $5,000, but only if the shop owner includes the $5,000 in Fred's W-2 at the end of the year. The idea is that basis is created with after-tax cash.

Years ago there were only two types of IRAs--deductible and nondeductible. They're now called traditional IRAs. Sue put $1,000 each year for 20 years into a deductible IRA. Since Sue got a deduction each year for the contribution, her basis in the IRA is zero. Putting the money in before taxes, as is done with most 401(k)s is the seme thing. You have no basis because the money was never taxed. On the other hand, in a nondeductible IRA the contribution is with after tax money so your basis is equal to what you contributed. If Sue put in $20,000 into a nondeductible IRA and it grew to $75,000 her basis would be $20,000. For every $1 she withdrew, part would be taxable and part a return of her investment.

The same can be true of other pension plans, annuities, and life insurance policies. You can purchase an annuity with after tax money. Distributions will be part a return of capital and part ordinary income. The issuer will send a Form 1099 with the split. The same is true of a whole life insurance policy. That's why cashing in a policy can result in significant tax consequences, depending on the holding period.

Business Equipment

This one is usually pretty simple. We're talking about any business asset that's tangible personal property. That includes a computer, vehicle, tractor, backhoe, desks, shop equipment, etc. It doesn't include real property such as an office building, retail store, factory, etc. Here your starting basis is the cost--cash plus debt assumed. There can be additions that add to basis such as adding a bucket to a tractor. Any depreciation taken reduces your basis. There are a number of depreciation methods but they all reduce your basis. Electing to expense the asset under Section 179 also reduces your basis.

Example--Madison purchases a tractor for $85,000 and claimed 100% bonus depreciation. In year two Madison's basis in the tractor would be $0. If the company sells the asset at this point for $70,000 its gain will be $70,000, all ordinary income from depreciation recapture.

If Madison sold the tractor for $90,000, the $85,000 of depreciation claimed would be ordinary income and the $5,000 amount received above the purchase price could be a capital gain.

If Madison elected out of bonus depreciation it would take $17,000 of depreciation in the first year and $13,600 in the second year (half-year of depreciation in the year of sale). At the time of sale Madison's basis in the tractor would be $54,400. If the tractor were sold for $80,000, Madison's gain would be $25,600, all ordinary income. If the tractor were sold for $90,000 Madison's gain would be $35,600, $30,600 would be ordinary income and $5,000 (the sale proceeds over the cost of the tractor) would be capital gain.

Rental Property

Rental real estate is slightly different. Real property is depreciated at a slower rate--over 27.5 years for residential real estate and 39 years for commercial property. The depreciation method is "straight-line" meaning 1/27.5 years or 1/39 years of the basis in the property over its lifetime.

Example--Fred and Sue purchased a lake home on August 1, 2023 for $340,000 to rent out. Except for cleaning and maintenance they don't intend to spend any time in the home. They allocated $40,000 to the land which is not depreciable. They take depreciation on the remaining 300,000. A full years' depreciation would be $10,909, but the depreciation is $4,091 in the first year because the property was purchased in August. The property is sold December 1, 2025 so depreciation for 2025 is only $10,454. The total depreciation while Fred and Sue owned the property was $25,454. Assuming no additions to the property the basis would be $340,000 less the total depreciation of $25,454.

Stocks, Bonds

While the rules can get complicated, usually there's nothing you have to do to prepare your return but take the numbers off your Form 1099/1099B from the broker. It usually has the proper basis (unless you purchased the security before 2011). But you should know that capital gain dividends from mutual funds will generally increase your basis in the fund because you've paid tax on the dividend and it's been reinvested in the fund. You may also encounter "wash sales". That's when you sell stock at a loss and within 30 days before or after you purchase the same shares. The loss on the sale is disallowed but added to the basis of your replacement shares. If you didn't get the stock by purchase through your broker things can get more complex quickly.

When selling stock different shares can have a different basis. For example, you bought 100 shares of Madison Inc. in 2005 for $20 each and 100 shares in 2023 for $75 each. If you can adequately identify the shares to your broker, sell the shares with the $75 basis for a lower gain otherwise it's assumed the first ones purchased are the first ones sold. In the case of mutual funds you can elect the average basis method.

Talk to your broker about the mechanics and make sure you understand before taking action.

Gifts and Inheritances

Most taxpayers know that if you inherit property your basis in that property is equal to its fair market value at the decedent's death. That can cut both ways. Fred bought 20 acres in Madison, VT for $50,000. On his death it passed to Sue and was valued at $125,000. Sue sells the property the next day for $125,000. She has no capital gain to report. Fred bought another 30 acres in Chatham, VT for $75,000. He left the property to Kristen and the estate valued the property at $60,000. Kristen's basis in the property is $60,000. Again, that's the general rule. There are some exceptions.

The rules change completely for property acquired by gift. But there's an added twist. Generally property acquired by gift is the donor's adjusted basis (sometimes called carryover basis). But if the property is sold at a loss, then the donee's basis is the lesser of the donor's basis or the fair market value on the date of the transfer of the gift. That's to prevent a taxpayer from gifting property with a low fair market value and the donee selling the property and claiming the loss.

However, for other purposes, such as calculating depreciation, the donee's basis is the donor's basis.

Transfers between spouses while married or incident to a divorce have a carryover basis. For example, Fred bought a vacation home in the 80's for $75,000; it's now worth $750,000. He married Sue after purchasing the house and in a divorce she's getting the property. Sue's basis will be $75,000. In addition, the basis-loss limitation rule doesn't apply in these types of transfers.

Like-Kind Exchanges

In a like-kind real estate is exchanged for other real estate and the new property takes the carryover basis of the old, unless a transfer of unlike property is included in the deal. Unlike property could be personal property such as a farm tractor or truck, or, more typically cash.

Example 1--Fred owns 10 acres of farmland with a basis of $20,000 and a fair market value of $100,000 that he no longer uses. A neighbor, Sue has q 50 acre woodlot with a basis of $35,000 worth $150,000 or $3,000 per acre. Sue wants the farmland and Fred is willing to accept the woodlot. Fred and Sue agree that Fred will transfer his 10 acres of farmland and Sue will transfer 33.33 acres valued at $100,000. After the deal is completed Fred owns a 33.33 acred woodlot with a basis of $20,000, the same as the property exchanged and Sue owns 10 acres of farmland with a basis of $23,331. The idea is that Fred and Sue's basis in the property received is equal to their original basis.

Example 2--Assume the facts are the same as in the first example but Fred wants Sue's full 50 acres. Fred and Sue exchange properties but, to make Sue whole because her property is worth $150,000, Fred gives Sue $50,000 in cash in addition to exchanging the property. Fred now has the full 50 acres with a basis of $70,000--$20,000 from his original basis and $50,000 from the about he paid Sue. Sue received $50,000 in the deal. Since that's unlike property, Sue has $50,000 in gross income from the deal.

Since you're keeping your original basis in the property any gain not reported is deferred until such time as you sell the property. That's the good news. The bad news is that your basis could be so low that if you need cash and have to sell, you could end up with an outsized gain.

S Corporations and Partnerships

We've saved the best for last. The basic theory is easy--it's the details that will drive you crazy. While basis in an S corporation, partnership, or LLC isn't simply, it's important because of potential tax consequences. We'll deal with a very simple, but typical situation first.

Your basis in a simple S corporation situation in the first year is calculated by: --Start with your initial equity investment
--Add (deduct) income (losses)
--Add separately stated income items (e.g., interest income, net rental real estate income)
--Deduct separately stated deduction items (e.g., charitable contributions, Sec. 179 deductions)
--Add any contributions to capital
--Deduct distributions to shareholders
=Ending basis

Your ending basis is the starting point for the next year and the calculations are the same, with the exception of your initial equity contribution. However, if you make an additional equity contribution, add that in.

You also have a basis in any loans you contributed to the S corporation. Those are separate computations and get trickier. The annual repayment of the loans will reduce your basis

Basis in S corporations and partnerships are critical because it determines your gain or loss if you dispose of your interest in the entity. In addition, you can't deduct losses that exceed your basis in the entity.

What about partnerships? The calculations are similar, but include an additional twist. Debt that you are responsible for increases your basis while paying off the loan decreases your basis.

--Last Update 08/11/26