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Leimberg’s
Think About It
Think About It is written by
Stephan R. Leimberg, JD, CLU
and co-authored by Linas Sudzius
MAY 2010
#411
WHAT EVERY FINANCIAL PROFESSIONAL
NEEDS TO KNOW ABOUT COST BASIS
INTRODUCTION
Financial planning professionals often help their clients position assets properly to meet the
clients’ financial goals. Sometimes this means liquidating certain assets in order to reinvest in
others. When a client decides whether or not to sell assets to buy others, the tax consequences
must be taken into account.
When assets are sold, gain or loss on the transaction is usually recognized for federal income tax
purposes. Gain is measured by comparing the net proceeds the client receives against the client’s
income tax basis, sometimes also called cost basis.
What is cost basis, how is it calculated and when is it important?
The IRS says that cost basis is the amount of investment in property or security for tax purposes.
It is used to figure gain or loss on the sale or other disposition of property. It is also used to
figure depreciation, amortization, and casualty losses.
Cost basis can be an especially important number for the owner of a closely held business. For
example, if the business is organized as an S corporation or partnership, the owner’s cost basis
may allow certain distributions to be tax free. Further, if the owner of a business sells to family
or a third party, cost basis will dictate how much of the sales proceeds are subject to capital gains
tax.
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In 2010, the concept of basis is even more important in the estate planning context. The
traditional step-up in basis rule has been replaced with a limited step-up rule, accompanied by
carryover basis rules for remaining assets. This change makes planning for the taxes associated
with a client’s death more problematic.
Many of our clients will look for our help in calculating the cost basis of their assets.
THE BASICS OF BASIS
Almost everything owned and used for personal, business or investment purposes is a capital
asset. Each asset owned by a taxpayer has its own cost basis. The starting point for calculating
basis is the taxpayer’s initial investment in the particular asset.
For federal income taxation purposes, the taxpayer’s initial investment depends on how the asset
was acquired. Here are the general rules with regard to initial investment and cost basis.
For assets purchased by the taxpayer, the initial investment equals the purchase price. See
Revenue Code Section 1012.
Assets acquired by gift receive carryover basis, under Code Section 1015. The donee’s basis is
usually equal to the donor’s basis on the date of transfer.
Assets acquired by inheritance in 2010 receive a limited stepped-up basis, discussed more fully
below.
Adjustments to Basis
An asset's basis can increase or decrease depending on changes that occur throughout its lifetime,
with those changes consolidating into the taxpayer’s adjusted basis.
INCREASES TO BASIS
Capital improvements, such as adding a room to a rental home, increase the asset's basis. Further,
government or association assessments for improvements, such as for sidewalks or roads, also
increase the basis for real estate.
In pass-through businesses, such as S corporations, partnerships or proprietorships, undistributed
business profit will also increase the owners’ basis in the business.
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DECREASES TO BASIS
Cost basis is often decreased by certain activities that improve today’s net cash flow. For
example, depreciation deductions diminish real property’s basis. Here are some other items that
might reduce a taxpayer’s cost basis in the underlying asset:
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Claiming a Section 179 deduction for the asset
Receiving nontaxable corporate dividends
Claiming casualty or theft losses
Receiving rebates
Taking certain tax credits, such as for qualified vehicles
Capital Gains and Losses
When a capital asset is sold, the difference between the basis in the asset and the amount it is
sold for is a capital gain or a capital loss. Gain is recognized if the asset is sold for more than its
cost basis, and loss is recognized if the asset is sold for less than basis. While capital gains are
nearly always taxable, losses may not be. For example, losses from the sale of personal-use
property are not deductible.
Taxable capital gains and losses may be long-term or short-term. Assets held for more than one
year before sale yield long-term capital gains or losses. Assets disposed of after less than a year
are considered short-term.
Capital gains are usually taxed at a rate lower than that imposed on other taxable income. To
figure the taxable capital gains for a given tax year, the taxpayer must calculate net capital gain.
First, the taxpayer aggregates all long-term capital gains and losses. Then the taxpayer calculates
net capital gains or losses.
Net capital gain is the amount by which all long-term capital gains for the year exceed the sum of
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short-term capital loss, plus
any long-term capital loss carried over from the previous year.
If long-term capital gains are less than short-term capital losses plus capital losses carried
forward, the taxpayer has a deductible capital loss. Capital losses are deductible against the
taxpayer’s income, but capped at an annual maximum of $3,000 ($1,500 if married, filing
separately).
If net capital loss is more than this limit, the taxpayer can carry the loss forward to later years.
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Capital Gains Tax Rates
The highest federal long term capital gains tax rate in 2010 is 15%. The highest rate in 2011 and
later—from today’s perspective—is scheduled to be 20%.
There are three exceptions to the 15% (or 20%) maximum capital gains rate:
1. The taxable part of a gain from selling Section 1202 qualified small business stock is
taxed at a maximum 28% rate.
2. Net capital gain from selling collectibles (such as coins or art) is taxed at a maximum
28% rate.
3. The part of any net capital gain from selling Section 1250 real property that is required to
be recaptured in excess of straight-line depreciation is taxed at a maximum 25% rate.
THE ADJUSTMENT AT DEATH
Traditional Rule
Traditionally, when a taxpayer died, all capital assets owned at death received a step-up in basis
to the full fair market value at the date of death. See Revenue Code Section 1014(a). Thus,
when heirs sold the property shortly after death, there was little or no tax on the sale.
Here’s an example. Say Judy owned 10,000 shares of publicly traded stock, which she
purchased in 1950 for $1 per share. Judy’s basis in the shares was $10,000.
In 2009, Judy passed away, leaving those shares to her daughter Connie. On the date of Judy’s
death, each share was worth $100, or an aggregate value of $1 million.
If Judy had sold those shares prior to her death, she would have had to pay capital gains tax on
the value received ($1 million) minus her basis ($10,000), or $990,000. If Judy’s capital gains
tax rate was 15%, she would have had to pay nearly $150,000 in capital gains tax.
However, since Connie inherited the shares, she received a step-up in basis at Judy’s death.
Connie’s basis is the fair market value of shares as of the date of death, or $1 million.
If Connie sold the shares the next day after Judy’s death for $1 million, she would pay no capital
gains tax.
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Carryover Basis
To understand the 2010 rules with regard to basis adjustments at the death of a taxpayer, it’s
necessary to consider the idea of carryover basis. Carryover basis is used in both the gift
context, and in sales of capital assets to spouse.
Gifts
For capital property transferred by gift, the donee’s basis is generally the same as in the hands of
the donor. Thus, the basis is considered to be carried over from the donor to the donee. If any
gift tax is paid as part of the transfer, the donee gets a partial increase in basis for the gift tax
paid. However, the carryover basis may not exceed the fair market value of the property at the
time of gift.
Sale to Spouse
In general, a sale of a capital asset to a spouse during both spouses’ lifetimes gives the
purchasing spouse carryover basis in the asset—no matter what consideration was actually paid
for the asset. See Revenue Code Section 1041.
2010 Special Rules
For calendar year 2010, the death-time adjustment of cost basis is a mixture of step-up and
carryover basis rules. See Revenue Code Section 1022.
When capital property is transferred at death, the step-up in basis is limited to an aggregate $1.3
million of increase in basis. The basis of property passing to a surviving spouse can be increased
by an additional $3 million. For capital property in excess of the step-up limits, the basis in the
hands of heirs will be treated under the carryover basis rules.
So if someone dies with $10 million in capital assets, which assets get the step-up in basis, and
which assets get carryover basis treatment? The short answer to that question is that it’s up to
the executor, or other fiduciary who is settling the decedent’s estate.
The special death-time basis adjustment rules of Section 1022 are scheduled to end in 2011, with
a return to the traditional step-up rule of Section 1014(a).
SPECIFIC ASSETS
The rules vary from asset to asset with regard to how basis is calculated, and what implications a
basis adjustment may have with regard to taxation of cash flow and ultimate disposition of the
asset.
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Marketable Securities and Mutual Funds
Certain kinds of securities may pay nontaxable distributions. Those distributions adjust the
taxpayer’s cost basis in the underlying investment.
For example, a mutual fund may pay a distribution reported as nontaxable. Such distributions
generally reduce the taxpayer’s basis in the shares.
If basis is zero, and such a distribution is made, the taxpayer must report the distribution as a
taxable capital gain.
Closely Held Businesses
Ownership interests in closely held businesses are capital assets. For a business organized as a C
corporation, cost basis is generally the amount the shareholder invested in the business.
However, for pass-through entities such as S corporations, partnerships and proprietorships,
calculating basis is not so simple. As with C corporations, the initial cost basis is generally equal
to the amount contributed by the owner to the business, or the amount the owner paid for the
business interest. In cases where the owner contributes appreciated property to the business, the
owner’s investment in the business is usually equal to the cost basis in the property.
Once the pass-through entity is up and running, cost basis changes almost continuously.
Here’s an illustration using an S corporation and just one 100% owner named Tom. The S
corporation calculates its income just like a regular corporation. However, rather than taxing the
corporation on those profits, Tom gets taxed on the business profit.
If the corporation makes $100,000 in profit, the corporation doesn’t pay the income tax on this
profit. Instead, Tom includes his share of the corporation profit—$100,000—in his taxable
income. Tom pays the taxes owed on the $100,000 of corporate profit on his individual income
tax return at his own tax rate.
Whether or not the S corporation actually distributes the $100,000 of profit to Tom is
irrelevant—the owner still must pay personal income taxes on that profit. However, distributions
from the S corporation to the shareholder do affect Tom’s basis in the S corporation stock.
Say that Tom made an initial investment into the company of $20,000 of his own money. His
initial cost basis would have been $20,000. Assume that there were no company profits or losses
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until Tom paid taxes on the $100,000. After that, Tom’s basis would have increased to
$120,000—his initial investment of $20,000 plus the $100,000 he included in income.
If Tom decides to take out $50,000 from the S corporation and put it in his own pocket, the
distribution is tax free. However, it also reduces his basis. After the $50,000 distribution, Tom’s
basis would be just $70,000.
Tom could take a further $70,000 out of the company—assuming the business could afford to
pay it—without having to pay income taxes on the distribution. However, once Tom’s basis is
reduced to zero, S corporation distributions made to him would be subject to capital gains tax.
If Tom’s business suffers a loss in the next tax year, Tom may deduct the loss on his personal tax
return. The deductible loss also decreases Tom’s basis in the S corporation.
While in this example we used an S corporation, the rules work in a similar way for other passthrough entities.
Real Estate
The initial cost basis for a piece of real estate is its purchase price. The purchase price includes
money paid out of pocket by the owner, as well as borrowed money used to finance the purchase
price.
In addition to money used to pay the purchase price, basis generally includes the following:
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Real estate taxes owed by the seller but paid by the buyer
Title fees
Legal fees associated with closing the transaction
Recording fees
Surveys
Transfer taxes
Basis for real estate generally does not include these items:
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Charges associated with getting a loan
Homeowners insurance premiums
Cost basis is important with regard to real estate for the usual purpose of figuring capital gains in
the event of the property’s sale. It’s also important with regard to most real property used for
rental or other business purposes to calculate tax deductible depreciation.
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Life Insurance
The basis of a life insurance policy is important for determining the tax treatment of policy
distributions during the insured’s lifetime. Basis for a life contract is aggregate premiums paid,
with adjustments for tax free distributions.
Living proceeds received—by withdrawal or dividend—under most life insurance contracts are
tax free up to basis in the contract. As with distributions to the owner of a pass-through business,
distributions from a life policy reduce the owner’s basis. Loans are not considered distributions.
If the contract is a modified endowment contract (MEC), distributions are taxed on a gain-first
basis. With a MEC, loans are considered distributions for tax purposes. Once all gain has been
captured in a MEC policy, distributions reduce basis.
Life insurance professionals often work with their clients to effect tax-free exchanges of the
clients’ life insurance policies under Section 1035 of the Revenue Code. Under an effective
1035 exchange, any gain in the policy being exchanged is not recognized. The new policy
carries over the basis of the old policy after the exchange.
Basis matters with regard to taxation of living proceeds from a life contract. In what other
instances does it make a difference?
SALE OF THE POLICY
With the emergence of the secondary market for life policies, the tax treatment of the sale of life
contracts has become an important issue. Last year, the IRS issued Revenue Ruling 2009-13,
which was designed to address many of the unanswered questions.
Prior to the ruling, there were two main schools of thought regarding the tax treatment of life
settlements.
The ordinary income position was simple. IRC Section 72 governs the income taxation of
amounts received during the insured’s lifetime. In cases where a contract is surrendered, the
amount of gain over the policyowner’s basis is taxable at ordinary income rates.
Advocates of the capital gain position for life settlements argued that the IRS itself, in PLR
9443020, said that Code Section 1001 should be applied to calculating basis for a life settlement.
Since that Code Section is designed to deal with capital assets, proponents argued that the IRS
was saying that life insurance is a capital asset.
In Revenue Ruling 2009-13, the IRS took a middle position. The IRS asserted that preliminary
basis must be reduced by the cumulative cost of life insurance protection (COI) during the
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ownership of the policy. Gain on the sale of the policy is calculated by subtracting that adjusted
basis from the sales proceeds.
The IRS held that the gain is partly ordinary income and partly capital gains. The Ruling states
the amount that would have been recognized as ordinary income if the policy had been
surrendered will also be considered ordinary income upon sale. To the extent the total gain
exceeds the amount that would have been ordinary income on surrender, it will be considered
capital gain.
The IRS did not explain anywhere in Revenue Ruling 2009-13 how COI should be calculated.
We will have to wait for more guidance to get a reliable answer.
STEP-UP OR CARRYOVER BASIS AT DEATH?
While the IRS concluded in Revenue Ruling 2009-13 that life insurance is a capital asset, it gave
no guidance about basis step-up when a third-party owner dies.
Here’s an example that illustrates that the question about basis step-up isn’t easy to answer. Say
that Ned owns a policy on Burt’s life. Ned has paid twenty annual premiums of $5,000 for the
$1 million policy. The policy now has cash value of $200,000. Assume Ned dies, passing the
policy to Burt, who is the contingent owner.
What is Burt’s basis? Does Burt get a step-up to $200,000 at Ned’s death, or does Ned’s basis of
$100,000 carry over? Does COI prior to Ned’s death act to adjust Burt’s basis?
We don’t know yet.
DEDUCTION OF LOSS
Can the surrender of a life contract ever generate a deductible loss for the taxpayer?
The IRS has consistently maintained that a loss deduction can be claimed only if the loss is
incurred in connection with the taxpayer’s trade or business or in a transaction entered into for
profit. See, for example, Private Letter Ruling 200945032, which allowed a loss deduction on
the surrender of a business-owned variable life contract.
Is the purchase of a personally-owned permanent policy a transaction entered into for profit?
Based on past case law, that’s not clear, so it’s also unclear whether any loss recognized on
surrender is deductible.
How is basis calculated when determining the potentially deductible loss on the surrender or
disposition of a life policy? Based on the logic in Revenue Ruling 2009-13 and Private Letter
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Ruling 200945032, the IRS seems to have taken the stance that net premiums paid must be
reduced by COI charges to figure basis.
Nonqualified Deferred Annuities
In most respects, calculating the cost basis of nonqualified deferred annuity contracts (NQDAs)
is simpler than calculating cost basis for life contracts, since annuities have no COI element.
Thus, for most NQDAs, the cost basis is equal to aggregate deposits minus the tax-free portion of
any distributions.
Gift transfers of NQDAs between spouses are not treated as income taxable dispositions of the
underlying contract. The recipient spouse carries over the basis of the former owner.
Gift transfers of NQDAs between non-spouses are treated as a surrender of the contract by the
transferring party. The new owner’s cost basis is the contract’s surrender value as of the date of
transfer.
With NQDAs, lifetime distributions are taxed on a gain-first basis. Once all gain has been
captured, distributions reduce basis.
As with life insurance, a key issue is the potential deductibility of a loss upon the NQDA’s
surrender. As with life insurance, the IRS has consistently maintained that a loss deduction can
be claimed only if the loss is incurred in connection with the taxpayer’s trade or business or in a
transaction entered into for profit.
NQDAs are different from life insurance in the respect that the IRS has conceded that
personally-owned annuities are usually purchased in a for-profit transaction. The IRS has also
maintained that losses associated with NQDAs are not capital losses, but ordinary income losses.
Ordinary income losses are generally deductible by individual taxpayers on Schedule A of Form
10540. Exactly where on Schedule A the losses are deductible has been the source of some
debate. The IRS maintains that annuity losses are miscellaneous deductions subject to the 2% of
gross income floor.
COST BASIS AND RECORDS
To substantiate cost basis when it is used in calculating taxes in taxable transactions, the taxpayer
must have records.
What if the taxpayer has no such records?
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One response is that the IRS will accept the taxpayer’s reasonable calculation of basis, so long as
the taxpayer is prepared to tell the IRS the methodology used. For publicly traded securities,
reconstructing basis might mean checking the purchase price from old newspapers, or rifling
through ancient checkbooks.
However, if the taxpayer truly cannot make a reasonable case for basis, the courts have said that
zero must be used. In Wilson v. Commissioner., T.C. Memo. 1996-418, the Tax Court said:
The taxpayer's basis in property is a question of fact, and the taxpayer generally has the
burden of proof on this issue. … Here, petitioners presented no evidence regarding their
basis in the …property, nor did they offer evidence of the basis …. Since there is no
proof that petitioners had any basis in the … property, we must treat the entire amount …
as gain realized.
CONCLUSION
Cost basis plays an important role in the tax lives of affluent clients. While the concept is
deceptively simple, the actual calculation of cost basis—especially for assets like closely held
businesses, real estate or life insurance—is not.
Our clients expect us to be able to help them make choices about generating cash flow and
whether disposition of assets makes financial sense. We aren’t able to help with a proper
analysis unless we know about the client’s tax situation, including the cost basis of the
underlying assets.
Now, in the middle of calendar year 2010, our traditional assumptions about basis step-up at
death have been placed up for grabs. This year’s rules, along with those that might take effect
next year, make planning for the taxes associated with a client’s death more problematic.
But with uncertainty comes opportunity. Those prepared to discuss the specifics of basis with
their clients and prospects are best positioned for a relationship of trust in the years to come.
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