What it means
Basis exists because tax is charged on gain rather than on proceeds. Selling a building for $2,000,000 tells you nothing about whether there is any profit until you know what the building counts as having cost, and basis is that figure.
The starting point, often called cost basis, is the purchase price plus the unavoidable costs of getting the asset into use: legal fees, delivery, installation, import duty and stamp taxes. Ordinary running costs and repairs are not included, because they are expensed as they arise rather than added to the asset.
Basis then moves over the life of the asset, which is where the term adjusted basis comes from. Capital improvements increase it, while depreciation or capital allowances claimed against tax reduce it, so a heavily depreciated machine can have a very low basis even though it still works perfectly well.
The practical consequence appears at the moment of sale. A low basis means a large taxable gain, which is why businesses that have claimed generous depreciation are sometimes surprised by the tax bill on equipment they thought they were disposing of for scrap value.
Two variants cause confusion. In commodities and futures markets, basis means the difference between the cash price of a physical commodity and the price of the related futures contract, and in interest rate work a basis is often used loosely to refer to the reference rate a floating charge is set against.
In practice
Real-world examples.
Example
A family business inherits a warehouse and assumes its basis is the price the founder paid decades earlier. The rules in many jurisdictions reset the basis to market value at the date of death, which dramatically changes the gain on a later sale.
Example
A restaurant group spends $90,000 fitting out a leased unit and adds the cost to the basis of the leasehold improvement rather than expensing it. The treatment spreads the deduction over the life of the fit out and raises the basis used if the lease is later assigned.
Example
A grain merchant tracks the basis between the local cash price and the futures price through harvest. When the gap narrows unusually, it takes the opportunity to sell physical stock and close out the hedge at the same time.
Think of it
“Basis is the gap between spot and futures prices-the difference between now and later delivery.
Formula
Calculation
Adjusted basis = original cost + acquisition costs + capital improvements - accumulated depreciation, and gain on sale = proceeds - adjusted basis
A printing business buys a press for $250,000 and pays $20,000 for delivery and installation, giving an original basis of $250,000 + $20,000 = $270,000. Over six years it claims $150,000 of depreciation against tax, so the adjusted basis falls to $270,000 - $150,000 = $120,000.
The press is then sold for $180,000. The taxable gain is $180,000 - $120,000 = $60,000, and at a 25% tax rate that produces a bill of $60,000 x 25% = $15,000, even though the press sold for less than it originally cost.Case study
Seen in the real world.
The following is an illustrative and fictional example. Larkfield Joinery, an invented workshop business, sold a computer controlled cutting machine for $180,000 and recorded the whole amount as a gain because the machine appeared in its accounts at zero. The bookkeeper had no record of the original cost or the improvements made along the way.
A fictional accountant reconstructed the history from old invoices and found $270,000 of original cost plus a $40,000 control system upgrade, against $260,000 of depreciation claimed. The adjusted basis was $270,000 + $40,000 - $260,000 = $50,000, so the real gain was $180,000 - $50,000 = $130,000 rather than $180,000.
The correction saved Larkfield tax on $50,000 of phantom profit and prompted the invented owner to start keeping a simple asset register recording cost, improvements and depreciation for every item over $5,000.
Watch out
Common mistakes.
- Treating the price on the invoice as the whole basis and ignoring delivery, installation and legal costs that properly belong in it.
- Adding routine repairs to basis, when only improvements that extend life or capability qualify.
- Forgetting that depreciation already claimed reduces basis, which understates the gain on eventual disposal.
Questions
People also ask.
Is basis the same as book value?
They are close and often equal, though book value follows accounting depreciation while tax basis follows the tax rules, and the two depreciation methods frequently differ.
What happens to basis when an asset is gifted?
It commonly carries over to the recipient, so the original cost history follows the asset rather than resetting, but the rules vary by jurisdiction and asset type.
Why does basis matter if the asset is never sold?
Because it determines annual depreciation deductions and it will matter eventually, and reconstructing it years later is far harder than recording it now.
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