Oregon Department of Revenue - Basis and Adjusted Basis Oregon Department of Revenue

This lesson covers the following topics:

Click the Start course button in the top right to begin. On the next page, you'll find a list of each module in this lesson. You can review the contents of any module by clicking the corresponding Start button. It is recommended that you review the modules in the order presented. 

You can return to review a completed module at any time.

Overview

Key Points

  • The basis of an asset is used to
    • compute depreciation, amortization, or depletion (business purpose)
    • compute the gain or loss (personal or business purpose)
  • Some items increase basis, others decrease the basis.
  • The sum of these changes to basis produce adjusted basis which is considered when computing loss or gain.
  • Examiners must be able to determine the correct basis and adjusted basis and make necessary adjustments.

Overview

An asset is a useful or valuable item. Property refers to possessions (assets), tangible or intangible, to which an owner holds legal title.

The basis of property is what it costs to take ownership of an asset. Because there are different ways to take ownership of property, there are different ways to compute basis. This lesson concerns computing the basis of assets purchased or constructed.

Basis is the starting point for computing depreciation, depletion, or amortization on property used in a trade or business. Basis, as used in the Internal Revenue Code, is also called cost basis or unadjusted basis. Basis is also the starting point for computing adjusted basis.

The adjusted basis of an asset is the basis, increased or decreased by certain amounts. The amount computed as adjusted basis is used to determine gain or loss on the sale, exchange, or other disposition of property. Property used in a trade or business and property held for personal use both start with adjusted basis to compute gain or loss.

Types of Property

Definitions

Tangible Property

Intangible Property

Tangible property can be seen or touched. Intangible property cannot be seen or touched.
Examples
Car Trade names
Machine

Licenses to operate

 

Patents

  Non-competition agreements

 

Real Property Personal Property
Real property is land and anything attached to it. Personal property is anything that is not real property and can be tangible or intangible.
Examples
  Tangible Intangible
Building Boats Patents
Crops Machinery Copyrights
Mineral rights    

 

Types of Property - Question

What are some common examples of the following types of property?

  • tangible
  • intangible
  • real
  • personal

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

tangible intangible real personal
car trade names buildings taxicab
machinery licenses to operate air conditioning systems shoes
clothing patents crops computer
boats covenants not to compete mineral rights
artwork copyrights barn
construction equipment goodwill house

 

Basis of Purchased Property

Cost Basis

Read IRC § 1012 and Treas. Reg. § 1.1012-1(a).

The basis of property purchased is the cost at the time it is acquired. Revenue Rulings and judicial interpretation define what is included in the cost basis of an asset purchased.

The cost basis of an asset can include:

  1. cash
  2. other property transferred (at adjusted basis)
  3. debt assumed - a mortgage or some other type of secured debt obligation
  4. incidental expenses of acquisition. Additional costs related to the purchase and delivery of an asset are capitalized and added to the basis of the asset. Any reasonable costs incurred to make an asset ready for its purchased use will also increase basis.

Examples of these types of costs are:

  • commissions, legal and recording fees, surveys, transfer taxes, and abstract fees that are settlement fees or closing costs.
  • costs of appraisal and survey,
  • title clearing and perfecting costs,
  • mortgage fees,
  • installation costs for machinery.

Let's look at some examples.

Example 1

Joe went to the local car dealer and purchased a new car. He gave the dealer $2,000 in cash and took out a loan of $13,000.

The basis of his car is $15,000.

Example 2

Tom and Barbara purchased a house on 1/4 acre of land right after they were married. They spent the following amounts:

cash as a down payment $20,000
mortgage 65,000
legal fees 800
recording fees 200
total basis of property  $86,000

Cost Basis - Exercise 1

Mr. Ripley made a $4,000 deposit on December 1, 2012, on a conditional contract to purchase a building and lot from Mr. Pratt. They signed the contract on January 1, 2013, at which time Mr. Ripley made a $12,000 down payment and gave Mr. Pratt a negotiable note of $40,000 secured by a mortgage on the property. The note called for payments of $2,000 on July 1 of each year for 20 years, with interest of 8% each year.

Compute Mr. Ripley’s basis in the property as of January 1, 2013 and enter it in the space below.

 

Cost Basis - Exercise 2

Determine the basis of the machine shown below, which was purchased for use in the manufacture of vinyl flooring and enter it in the space below.


 

purchase price (cash) $30,000
finder's fee to locate machine 1,500
delivery cost 2,000
installation 8,000
major reconditioning before placing in service 10,000
electricity to run the machine 800
minor repairs after being placed in use 2,000

Cost Basis - Question

What type of information might an auditor ask for from a taxpayer to verify equipment purchases claimed on their tax return?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

Possible responses to the question include:

  • Purchase invoices for the equipment,
  • cancelled checks for payment of the equipment, etc., that the taxpayer is using
  • oral testimony. 

If the taxpayer did not have that information, how else could an auditor get it?

  • Call several vendors to see how much they believed the equipment sold for in the year the taxpayer purchased it.
  • Ensure their stated cost is approximately comparable to the cost.

There are many times an auditor will not receive receipts for questioned items. Alternative methods of determining the correct amount must be explored.

Apportioning Property Taxes on Sale of Real Estate Property

IRC § 1012 specifically addresses the subject of real property taxes when property is sold. The rules for apportioning real estate taxes between seller and purchaser are in IRC § 164(d).

Read Treas. Reg. § 1.1012-1(b).

The owner of real property is liable for real estate tax imposed on the property. When real property is sold during the year, part of the annual tax is imposed on the purchaser, and part is imposed on the seller. It is allocated based on the number of days in the real property tax year that each holds the property. This is usually handled on the escrow closing statement.

The allocation of real estate tax is required whether or not the seller and purchaser actually do so.

Computations

There are 3 typical scenarios when property is sold:

Scenario 1

Seller pays the whole year’s real estate tax in the year of sale. Treatment depends on whether the purchaser reimburses the seller for the purchaser’s share of the tax. If the purchaser reimburses the seller for that amount, in addition to the cost of the property, there is no effect on the purchaser’s basis. If the purchaser does not reimburse the seller, the seller is entitled to a credit at the time of sale. A portion of the purchase price will be allocated to reimburse the seller, and the cost basis of the property is decreased by the amount of the tax.

Example 3

Sue sells farmland to John for $10,000 and pays the entire annual real property tax of $300 before the sale. Based on John’s holding period, $100 of the tax is allocable to him. John reimburses Sue with a separate payment of $100 (aside from the selling price of $10,000) for his share of the tax. The $100 has no effect on John’s cost basis. John can claim a deduction for $100, and his cost basis in the property will be $10,000.

 

Example 4

The facts are the same as in Example 3, except John does not reimburse Sue for his allocable share of real estate taxes. IRC § 1012 applies whether or not a specific reimbursement is made. Therefore, John’s cost basis will be $9,900, the $10,000 sales price less $100, John’s allocable share of the real estate taxes. John can claim a deduction for $100 for his allocation of the tax.

 

Scenario 2

If real property taxes are not paid before the date of sale, both the purchaser and seller usually pay their allocable share at the time of sale, and each claims a deduction for their portion of the tax. There is no effect on the basis of the property. Each can deduct his/her share of the tax paid at the time of closing the sale.

Scenario 3

If the purchaser pays the whole year’s real estate tax at the time of sale, the purchaser includes, as part of the cost basis in the property, any amount paid to the seller (or paid for the seller) that are allocable to the seller’s share of the tax. The purchaser cannot claim the portion of the tax imposed on the seller as a deduction.

Example 5

The facts are the same as in Example 3, except that Sue does not pay the $300 real property tax before the sale, and John pays it in full with a separate payment. John’s cost basis will be $10,200, the $10,000 sales price plus $200, which is Sue’s allocable share of the real estate taxes. (Treas. Reg. § 1.1012-1(b)). John will claim the $100 deduction for his allocable share. The amount realized by Sue is $10,200, and she can deduct her allocable share of the taxes.

This figure provides a review of the above scenarios.

Scenario   Purchaser Basis Seller Income Purchaser and Seller Deduction
Seller pays whole year's tax Purchaser reimburses

Same as

purchase price

Same as 

purchase price

Pro rata share
Purchaser does not reimburse Reduced by Purchaser share Reduce amount realized on sale Pro rata share
Seller and Purchaser pay at date of sale  

Same as

purchase price

Same as

purchase price

Pro rata share
Purchaser pays whole year's tax Seller reimburses

Same as

purchase price

Same as

purchase price

Pro rata share

Computations - Exercise 3

Kevin purchased a building from Mark for $70,000. Real estate tax of  $3,000 was not paid before the time of sale. The total amount of $3,000 is attributable to Mark’s holding period; but Kevin paid the taxes in addition to the $70,000 purchase price of the building.

What is Kevin’s basis in his new building? Enter it in the space below. 

 

 

Question 1

An auditor is auditing a taxpayer who has claimed a depreciation deduction on his rental property. The TCO is trying to verify the basis of the building. What item(s) would the auditor request from the taxpayer to verify the basis and the deduction?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

  • Real estate tax bill for percentage of land to building
  • Closing statement from the escrow company to verify the cost of the property (ensuring the taxpayer is the owner and indicating whether he owns the property with someone else).

Question 2

If an auditor found that the taxpayer owned property with another party, what should the auditor do?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

Ask the taxpayer about the ownership and any agreements with the other owner. Check the other party’s tax return to see what deduction was taken. If each taxpayer did not take the proper deduction, make audit adjustments on both returns.

Note that the auditor should not disclose any information to the other party during the examination, and be sure to follow proper procedures to obtain third-party information.

Basis of Constructed Property

Direct and Indirect Costs

The basis of an asset that is built instead of purchased includes direct costs (materials and labor) and indirect costs. Costs can include:

  1. the cost of building materials,
  2. architect’s fees,
  3. fees for building permits,
  4. fees paid to subcontractors,
  5. payments for equipment rented to complete the construction,
  6. depreciation deductions on equipment for the time it is used in the construction,
  7. operating and maintenance costs for equipment used in the construction,
  8. the cost of supplies consumed in the construction,
  9. other construction costs, and
  10. wages paid to employees for their work on the constructed asset during the building process.

Designated Property

Read IRC §§ 263A(f)(1) and (4) and Treas. Reg. § 1.263A-8(b)(1).

Interest incurred to finance the production or construction of designated tangible personal property to be used in a trade or business or held for investment is capitalized and added to the basis.

Designated property is:

  1. real property,
  2. personal property with a class life of 20 years or more,
  3. personal property with an estimated production period of more than 2 years, and
  4. personal property with an estimated production period of more than 1 year and an estimated cost of production in excess of $1 million.

A full discussion of capitalized interest is beyond the scope of this training.

Key Points

Interest incurred to finance the production or construction of designated real or tangible personal property is capitalized and added to the basis.

Designated Property - Exercise 4

John Snow owns a cabinet-making shop. In 2013, he puts an addition on the building where the cabinets are manufactured. He spent the following amounts during the construction period: 

Compute Mr. Snow’s basis in the building addition and enter it in the space below.

 

architect's fees $1,000
building permit 500
roofing material 1,500
lumber (half used for the addition, balance used to construct cabinets produced for sale to the public.) 12,000
wages paid to the employees of the company, who spent 1/3 of their time building the addition. 30,000
siding and exterior finish materials 5,000
interior finish materials 4,000
electrical subcontractor 3,000
plumbing subcontractor 2,000
Interest on a line of credit during the production period to finance the addition. 900

 

Property Acquired at a Bargain Price

Related Parties

Sales or purchases of property between related parties (family members, corporations and their stockholders, etc.), or others where the transaction is not at arm's length, require special scrutiny to determine whether the price assigned is the fair market value (FMV) of the property. There may be transactions where the purchase price is more than FMV, and others where the purchase price is less than FMV.

Frequently, purchases at other than FMV stem from a business relationship (employee/employer, independent contractor/business owner, etc.). Some bargain purchases arise from a family relationship.

If property is transferred at other than its FMV, the difference is usually a gift, compensation, or dividend. The treatment will depend on the relationship. The auditor must research the issue to make a determination based on the facts and circumstances of each case.

Key Points

  • Sales or purchases of property between related parties (family members, corporations and its stockholders, and a partnership and its partners) require special scrutiny to determine whether the price assigned is the fair market value (FMV) of the property.
  • Auditors may find transactions in which the purchase price is more than FMV and other transactions where the purchase price is less than FMV.
  • If property is transferred between related parties at other than the property’s FMV, the difference is a gift, compensation, or dividend.
  • While most purchases at other than FMV stem from a business relationship, some bargain purchases arise from a family relationship.

Example 6

Mr. Pomona purchased stock in York Company from his daughter. The stock of York Company is publicly traded on the New York Stock Exchange. Mr. Pomona paid $80 per share though the stock had a FMV of $50 per share. Later he sold the stock for slightly less than $50 per share and claimed a loss on his tax return, using $80 per share as his cost basis. Mr. Pomona is entitled to a cost basis of only $50 per share; the remainder of the purported purchase price represents a gift to his daughter.

Related Parties - Question

What questions might an auditor ask the taxpayer during the initial interview in regard to related party transactions?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

  • Did the taxpayer sell, receive, or give anything to a relative?
  • Is the taxpayer a shareholder in a corporation or a partner in a partnership? If so, did the taxpayer receive any property instead of compensation for services; receive anything from the corporation or partnership, such as a gift; or get a piece of property at a bargain price?

Allocation of Basis

Lump Sum Acquisitions

Just as there are different ways to acquire an asset, there are different ways to treat an asset for tax purposes. Some assets are depreciable, and others are not. Depending on the type of asset, the life and method of depreciation may vary. Other assets acquired, such as inventory, are claimed as an expense in the course of doing business.

When a taxpayer acquires a group of assets for a lump sum, the purchase price is allocated among the individual assets. Expenses incident to the total purchase are allocated to each asset purchased. An expense attributable to a specific asset will be assigned to that asset.

Key Points

  • There are different ways to treat an asset for tax purposes.
  • Some assets are depreciable and others are not. Depending on the type of asset, the life and method of depreciation may vary.
  • Other items acquired, such as inventory, are claimed as an expense in the course of doing business.
  • When a taxpayer acquires multiple assets for a lump sum amount, the
  • purchase price is allocated among the individual assets.
  • Expenses incident to the purchase of property are allocated proportionately to each asset purchased (such as closing costs).
  • Land, buildings, inventory, equipment, and a covenant not to compete can be purchased in one transaction.
  • An auditor must determine the basis of each separate asset.

Purchase of Trade or Business

IRC § 1060 provide the asset allocation rules for the purchase of a trade or business. A discussion of IRC § 1060 is beyond the scope of this lesson.
 

Purchase of Land and Building

A common lump sum purchase is the purchase of real property that includes nondepreciable land and a depreciable building.

The purchase price is allocated based on the proportion that each asset’s FMV bears to the total FMV of the property. The computation is as follows:

The best determination of FMV for the allocation of purchase price is an actual appraisal by a professional who has expertise in the kinds of property being purchased. The assessed value for real estate tax purposes can be used if an appraisal is not available.

Let's look at a few examples.

Example 7

Jim purchased a house from an unrelated party to use as a rental property. He paid $200,000. The house is valued at $120,000; and the land the house sits on is valued at $30,000 ($150,000 total). The basis of each component of the property is computed as follows:

Example 8

Robert purchases 500 acres of farmland for $80,000 from an unrelated party. The FMV of the land is $40,000; and the FMV of the fences is $10,000. The basis of the land is $64,000; and the basis of the fencing is $16,000, computed as follows:

Example 9

Mr. Calvin purchases an apartment house for $100,000. The property includes a 3-unit apartment building situated on one acre of land. Each apartment is furnished. A property tax assessment valuation made near the time of sale shows a land value of $25,000 and a building value of$55,000. The agreement of sale provides a stated cash price of $5,000 for the furniture. Basis is determined as follows:

Key Points

These examples are highly consistent with real life, and you may see the same situations in your examinations. Take note of the computation and how the solution was reached.

Purchase of Land and Building - Exercise 5

Mr. Bates purchased a commercial building for $250,000 from an unrelated party. Included in the purchase were two acres of land that were assessed a value of $50,000 at the time of sale. The building was assessed a value of $150,000.

Determine the basis of the land and enter it in the space below.

 

Determine the basis of the building and enter it in the space below.

 

 

Purchase of Land and Building - Question

What might an auditor need to do to verify the basis of the property during an audit?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Responses

  • verify the date of acquisition
  • substantiate the cost or other basis
  • allocate the cost if multiple assets were acquired
  • establish whether an arm’s length transaction took place
  • inspect original documents such as purchase contracts, broker’s, statements, sales invoices, deed records, and mortgage records

These documents, produced by independent third parties, help establish the date a transaction occurred, what assets were purchased, and the purchase price.

Adjusted Basis

Overview

As previously discussed, basis is defined by IRC § 1012. Basis is the amount used when computing depreciation or amortization on assets used in a trade or business or held for investment.

It is also the starting point for computing adjusted basis. With property ownership, various transactions can take place that affect basis. When the property is sold, these adjustments to basis are taken into account when computing whether the sale results in a gain or a loss.

Read IRC § 1011(a). This section states how adjusted basis is computed.

Read IRC §§ 1016(a)(1) and (2). Also, the balance of this Code section has many items that will have an effect on basis. The most common adjustments to basis will be discussed in this lesson.

Amounts Allocated to a Capital Asset

Read Treas. Reg. § 1.1016-2(a).

The basis of property increases or decreases for any expenditure, receipt, loss, or other items added to the capital asset. Capital expenditures were discussed in the previous lesson. A common adjustment to basis is for improvements or betterments to the property. Improvements add to the value of the property, lengthen its useful life, or adapt it to a different use.

It is important to distinguish between improvements and repairs. Repair and maintenance expenses only keep an asset in normal operating condition and do not prolong useful life or add to the value of property. For example, replacing a few shingles on a roof is a repair. Replacing the entire roof is an improvement or capital expenditure.

If repairs or maintenance costs are for property used in a trade or business, they are claimed as an expense when paid for (cash basis taxpayer).

Improvements are added to the capital asset and are not claimed as a current expense.

Key Points

  • The basis of property increases or decreases for any expense, receipt, loss, or other item allocable to a capital asset.
  • A common adjustment to basis is for improvements or betterments to the property.
  • Remember to distinguish between improvements and repairs.
  • Improvements add to the value of the property, lengthen its useful life, or adapt it to a different use.
  • Repairs keep an asset in normal operating condition and do not prolong the useful life or add to the value of the property. Replacing a few shingles on a roof is a repair, while replacing the entire roof is an improvement or capital expense.
  • Repairs or maintenance costs are for property used in a trade or business. They are claimed as an expense when paid. Improvements are allocated to the capital asset and are not expenses when they are paid.

Amounts Allocated to a Capital Asset - Exercise 6

In this case, the value of the property and the cost are the same. Expenses of purchase and the closing costs must be allocated to each asset purchased, specifically, the land and the building.

Please review the calculation.

  Building Land
Allocated purchase price $30,000 $10,000
Allocated expense of purchase 3,000 1,000
Basis $33,000 $11,000

Jill purchased a rental property in May 2013. The purchase price was $40,000. The land was valued at $10,000 and the building at $30,000.

During 2013, Jill incurred the following expenses:

legal fees and transfer fees paid at closing $4,000
new siding purchased August 2013 6,000
utilities 1,200
repairs (all minor) to furnace, plumbing, and storm windows paid at various times 600
cost of new water heater 600

At the time of purchase, what is the basis of the building? Enter your response in the space below.

 

At the time of purchase, what is the basis of the land? Enter your response in the space below.

 

Amounts Allocated to a Capital Asset - Exercise 6

Part B

Jill purchased a rental property in May 2013. The purchase price was $40,000. The land was valued at $10,000 and the building at $30,000.

During 2013, Jill incurred the following expenses:

legal fees and transfer fees paid at closing $4,000
new siding purchased August 2013 6,000
utilities 1,200
repairs (all minor) to furnace, plumbing, and storm windows paid at various times 600
cost of new water heater 600

What is the adjusted basis of the building? Enter your response in the space below.

What is the adjusted basis of the land? Enter your response in the space below.

 

Amounts Allocated to a Capital Asset - Question

Where would an auditor look on the return or taxpayer records to see amounts that have been expensed instead of added to basis of the property?

Take a moment to think about the response, then click the Next button to review some possible answers.

Possible Reponses

Possible responses to the question include: 

  • repair expense
  • supplies expense
  • legal expense
  • miscellaneous expense

Capital Recoveries

Treas. Reg. § 1.1016-2(a) states that receipts or losses chargeable to the capital asset are an adjustment to basis.

A casualty loss is an example of an adjustment to basis of a capital asset. A casualty loss is the total or partial destruction of property, and may be deductible on a tax return. The amount of loss deducted reduces the basis of the property.

Any insurance or other reimbursement received when a casualty loss occurs also reduces the basis of an asset. Any amount spent to restore damaged property will increase the basis.

Computation of casualty losses will be discussed in another lesson.

Let's look at an example.

Example 10

Robert had a flood in his bicycle shop that caused damage of $10,000. He received $8,000 from insurance and deducted a $2,000 loss on his return (for which he received a tax benefit). The basis of the bicycle shop is reduced by $10,000 (the $8,000 of insurance received and the $2,000 loss claimed). Any amount he spends to restore the bicycle shop will be an addition to basis.

Capital Recoveries - Exercise 7

In January 2013, Mr. Bates built a small factory building on a piece of land that he owned. The factory cost $80,000 to construct. In March 2013, a fire destroyed the top floor of the factory, causing damages of $15,000 to the building. The insurance company paid $10,000 in reimbursement, and Mr. Bates claimed a casualty loss of $5,000 on his return. He spent $12,000 repairing the damage and restoring the property.

What is his adjusted basis in the property? Enter your response in the space below.

 

Depreciation Amortization Depletion

Read IRC § 1016(a)(2).

The basis of property decreases for any depreciation deduction or cost recovery, allowed or allowable, relating to the property.

Depreciation is a method of recovering the cost of an asset over its estimated useful life by claiming a portion of the cost as a deduction in each year. This depreciation deduction reduces basis under the theory that if a part of the cost is claimed as an expense, it cannot be claimed again as part of the cost basis. Basis is also adjusted for any amount claimed as an IRC § 179 deduction.

The methods for computing depreciation and the IRC § 179 deduction are covered in later lessons.

Key Points

  • Basis of the property is reduced by any depreciation, amortization, ordepletion allowed or allowable.
  • Depreciation is a method of recovering the cost of an asset over its estimated useful life by claiming a portion of the cost as a deduction in each year.
  • This depreciation deduction reduces basis under the theory that if a part of the cost is claimed as an expense it cannot be claimed again as part of the cost basis. Basis is also adjusted for any amount claimed as an IRC § 179 deduction.
  • Amortization and depletion are similar to depreciation.
  • Amortization is the recovery of cost of intangible assets.
  • Depletion is used for mineral property such as oil or gas wells, and for standing timber.
  • The amounts claimed as amortization or depletion adjust the basis of the property.

Let's look at an example.

Example 11

Carl purchased machinery for use in his candy-making business in January 2006. The machinery had a basis of $20,000 and a useful life of 10 years. Each year, beginning in 2006, Carl deducted $2,000 in depreciation ($20,000 divided by 10). At the end of 2013, the adjusted basis of the machinery would be $4,000 ($20,000 – $16,000).

Amortization and depletion are similar to depreciation. Amortization applies to certain capital expenses that are not depreciable such as research expenses. Depletion is used for natural resources such as oil and gas wells and for standing timber. The amounts claimed as amortization or depletion adjust the basis of the property.

Depreciation Amortization Depletion - Exercise 8

In 2011, Ivan paid $24,000 for a delivery truck to use in his business. He claimed depreciation in 2011 of $4,800 and of $7,680 in 2012. On January 1, 2013, he traded the truck in and purchased a larger one.

What is the adjusted basis of his truck at the time of trade-in? Enter your response in the space below.

 

Key Point

For certain assets acquired before January 1, 1986, investment tax credit was allowed. The basis of the property should be reduced by one-half the credit claimed.

Credits

Prior to the Tax Reform Act of 1986, there was an investment tax credit allowed on certain capital assets that were purchased. This credit was repealed. Still in place is a rehabilitation tax credit, which allows for the rehabilitation of old or historic structures. If investment tax credit was claimed on an asset, the basis of the property is normally reduced by one-half of the credit. Therefore, an auditor should review the basis of assets acquired before January 1, 1986.

Exam Techniques

Exam Techniques

  1. An auditor should take four actions when examining the basis of property:
    • verify the date of acquisition.
    • substantiate the cost or other basis.
    • allocate the cost if multiple assets were acquired.
    • establish whether an arm’s length transaction took place.
  2. When possible, original documents such as deeds, purchase contracts, broker’s statements, sales invoices or settlement sheets should be inspected. These documents help establish the date a transaction occurred, the purchase price, and the name of the other party to the transaction.
  3. Purchases of real property are published in public records. The county where the property is located will have information such as the date of sale, deed records, and mortgage records and microfiche copies of legal documents. The purchase agreement may not specify the total purchase price, but county records will usually have a record of the real estate transfer tax paid, which can be used to calculate the price. The property valuation for local tax purposes may be helpful in allocating the basis between land and building
  4. If the taxpayer does not have sales invoices for equipment purchases, cancelled checks or other secondary information can be used.
  5. If the taxpayer does not have any of the above original documents, it is possible they may be obtained from third parties. However, strict rules govern the contact of third parties for information needed in a tax examination. These rules are covered in a later lesson.
  6. An auditor should always ask during the initial interview whether the taxpayer had any transactions with related parties during the year under examination. If in doubt as to whether a transaction was “at arm’s length,” contacting third parties to establish fair market value (FMV) should be considered but first ask the taxpayer to support the basis.
  7. Often, local libraries have information available to establish values of various types of property. Inspecting the tax return of the related party to the transaction may be necessary. The Privacy Act and disclosure rules apply to confidential information, such as a tax return.
  8. An auditor should consider examining amounts claimed as repairs, supplies, or legal fees. Frequently, these expenses claimed by the taxpayer are capital in nature and must be added to basis rather than currently deducted.

Summary

Summary

  1. The basis of purchased property is its cost. The cost is the cash or other property paid, including debt assumed, plus any costs to acquire the property.
  2. Real property taxes are allocated between the seller and purchaser in the year of sale. Taxes imposed on the seller that are paid by the purchaser are part of the purchaser’s basis.
  3. The basis of property constructed includes the cost of building materials, architect’s fees, depreciation on equipment used, employee wages, or any other cost related to the construction of the property.
  4. A purchase or sale involving related parties that is not reasonable in relation to the fair market value (FMV) of the property could involve a gift, compensation, or a dividend.
  5. When assets are purchased in a group for a lump sum, the purchase price must be allocated among the various assets.
  6. Expenditures for improvements that add to the value of property are added to a capital asset and increase the basis of an asset.
  7. The basis of an asset is decreased by any deductible loss to property and by any insurance or other reimbursement received for damage to property.
  8. Amounts spent to restore an asset after damage by casualty increase the basis.
  9. The basis of property is decreased by any depreciation allowed or allowable. The same is true for amortization and depletion.