Cost basis is the amount a taxpayer put into property, and it is the figure a later gain or loss is measured from. The Code states it in one line and then spends several sections qualifying it: the basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C, relating to corporate distributions and adjustments, K, relating to partners and partnerships, and P, relating to capital gains and losses (26 U.S.C. 1012(a)).
Two words in that sentence carry the whole term. Cost is what the taxpayer paid, not what the property was worth. Except is the reminder that cost is only the starting rule, and that a great deal of property never has a cost basis at all because it was inherited, received as a gift, or received in an exchange, in which case a different section supplies the number.
What Counts as Cost
The regulation answers the question the statute leaves open, and its answer is narrower than most people expect. In general, the basis of property is the cost thereof, and the cost is the amount paid for such property in cash or other property (26 CFR 1.1012-1(a)). The same paragraph repeats the statute’s carve-out, noting that the general rule is subject to exceptions stated in subchapter O, relating to gain or loss on the disposition of property, and in subchapters C, K and P (26 CFR 1.1012-1(a)).
Amount paid in cash or other property is the test. A price agreed and not paid is not cost, and a value estimated is not cost.
One item is expressly pushed out of cost, and it is the one that appears on every closing statement for real property. The cost of real property shall not include any amount in respect of real property taxes which are treated under section 164(d) as imposed on the taxpayer (26 U.S.C. 1012(b)). The regulation runs the rule in both directions, and it opens by naming what it applies to. In computing the cost of real property, the purchaser shall not take into account any amount paid to the seller as reimbursement for real property taxes treated under section 164(d) as imposed upon the purchaser, and this applies whether or not the contract calls for that reimbursement; but where the purchaser pays, or assumes liability for, real property taxes treated as imposed upon the seller, those taxes are considered part of the cost of the property (26 CFR 1.1012-1(b)). The contract’s own wording is deliberately made irrelevant: it is immaterial whether or not the contract of sale specifies that the sale price has been reduced by, or is in any way intended to reflect, real estate taxes allocable to the seller under section 164(d) (26 CFR 1.1012-1(b)). The apportionment those rules turn on is set out in real estate tax.
Cost Basis and Adjusted Basis Are Two Different Numbers
Cost basis is the opening figure. It is almost never the figure used at a sale, because a separate section moves it, and moves it whether or not anyone tracked the movement.
The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, is the basis determined under section 1012 or other applicable sections, adjusted as provided in section 1016 (26 U.S.C. 1011(a)). Section 1016 is not permissive about it: proper adjustment in respect of the property shall in all cases be made for expenditures, receipts, losses, or other items, properly chargeable to capital account (26 U.S.C. 1016(a)(1)). That first paragraph then carves items back out in two subparagraphs, and the first of them names two: no such adjustment is made for taxes or other carrying charges described in section 266, or for expenditures described in section 173 relating to circulation expenditures, for which deductions have been taken by the taxpayer in determining taxable income for the taxable year or prior taxable years (26 U.S.C. 1016(a)(1)(A)).
The downward adjustment is the one that catches people out, because it does not wait for anybody to claim anything. Adjustment shall be made in respect of any period since February 28, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount allowed as deductions in computing taxable income and resulting, by reason of the deductions so allowed, in a reduction for any taxable year of the taxpayer’s taxes under this subtitle, other than chapter 2 relating to tax on self-employment income, or prior income, war-profits, or excess-profits tax laws, but not less than the amount allowable under this subtitle or prior income tax laws (26 U.S.C. 1016(a)(2)). Read the closing clause. Basis comes down by at least the depreciation that was allowable, whether or not it was ever actually deducted. A taxpayer who skipped depreciation on a rental for a decade does not keep the higher basis. The statute also supplies the default method where none was chosen: where no method has been adopted under section 167, the amount allowable is determined under the straight line method (26 U.S.C. 1016(a)(2)).
How that same reduction is computed on the depreciation side is set out in depreciable basis, and what happens to the difference at a sale in depreciation recapture.
Where the Broker’s Number Comes From
For most individual clients the cost basis on a return arrives pre-computed, and it is worth knowing what rule produced it.
If a broker is otherwise required to make a return with respect to the gross proceeds of the sale of a covered security, the broker shall include the customer’s adjusted basis in such security and whether any gain or loss with respect to it is long-term or short-term within the meaning of section 1222 (26 U.S.C. 6045(g)(1) and (g)(2)(A)). The default it uses is set by statute rather than by the firm. For purposes of that requirement, the customer’s adjusted basis is determined, in the case of any security other than stock for which an average basis method is permissible under section 1012, in accordance with the first-in first-out method unless the customer notifies the broker by means of making an adequate identification of the stock sold or transferred (26 U.S.C. 6045(g)(2)(B)(i)(I)). For stock where averaging is permissible, it is the broker’s default method unless the customer elects another acceptable method for the account (26 U.S.C. 6045(g)(2)(B)(i)(II)).
Two consequences follow for a preparer. The number on the statement is a default unless somebody chose otherwise before the trade settled, and the choosing is what the rules on identification govern, which are set out in specific identification method and FIFO. The long-term or short-term flag is a second reported item and it rests on the clock described in holding period.
When There Is No Cost
Much of the property a firm sees was never bought by the person who now owns it, so section 1012 never applies to it.
Property acquired from a decedent takes a basis fixed at death rather than a cost, and property received by gift takes the donor’s history rather than a cost. Both routes, and the loss rule that makes a gift different from an inheritance, are set out in step-up in basis.
Common Questions
Not quite, in either direction. Cost is the amount paid for the property in cash or other property (26 CFR 1.1012-1(a)), which can exceed a headline purchase price where the buyer assumes the seller’s real property taxes (26 CFR 1.1012-1(b)), and which excludes the buyer’s own apportioned share of those taxes (26 U.S.C. 1012(b)).
Because section 1016 requires it. Proper adjustment in respect of the property shall in all cases be made, which is a command rather than an option (26 U.S.C. 1016(a)). The figure that started as cost is a running balance from the moment the property is acquired.
The obligation does not go away. Gain or loss is measured from adjusted basis under section 1011 whatever the records look like (26 U.S.C. 1011(a)), so an unsupported basis is a substantiation problem rather than a basis of zero by rule. Reconstructing it from purchase records, corporate action history and prior returns is the work.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own basis reconstruction and Schedule D work through a trial task before anything client facing depends on it.
