If there is one topic that threads through virtually every area of the REG section, it is basis. Basis determines how much gain or loss is recognized when property is sold, exchanged, or distributed. It affects individual tax, corporate tax, partnership tax, and estate and gift tax. Getting basis calculations right is not just helpful for the CPA exam; it is essential. Examiners know that basis is a concept that separates candidates who truly understand tax law from those who have only memorized rules, and they test it extensively.
This article covers the major basis concepts you need to know for the REG section, from initial basis through adjusted basis, with special attention to partnerships, S corporations, like-kind exchanges, gifted property, and inherited property.
Initial Basis: The Starting Point
The initial basis of property depends on how it was acquired:
Purchased Property
The initial basis of purchased property is its cost, which includes the purchase price plus any costs necessary to acquire the asset and place it in service (such as sales tax, freight, and installation costs).
Property Received for Services
When property is received as compensation for services, the basis equals the fair market value (FMV) of the property at the time it is included in income.
Property Converted from Personal to Business Use
When personal-use property is converted to business use, the basis for depreciation purposes is the lesser of the adjusted basis or the FMV at the time of conversion. For determining loss on a later sale, the basis is also the lesser of adjusted basis or FMV at conversion. For determining gain, the original adjusted basis is used.
Adjusted Basis
Adjusted basis starts with the initial basis and is then modified for certain events over the holding period:
Adjusted Basis = Initial Basis + Additions - Reductions
Common additions to basis include:
- Capital improvements
- Legal fees to defend or perfect title
- Assessments for local improvements (such as sidewalks)
- Costs of restoring damaged property
Common reductions to basis include:
- Depreciation, amortization, and depletion (allowed or allowable)
- Casualty loss deductions
- Insurance reimbursements for losses
- Section 179 expense deductions
- Nontaxable distributions (return of capital)
Exam tip: Depreciation reduces basis whether or not it was actually claimed on the tax return. The reduction is for the amount "allowed or allowable," meaning the greater of the amount actually deducted or the amount that should have been deducted.
Partnership Basis
Partnership basis is one of the most complex and heavily tested basis topics. A partner's basis in a partnership interest (called the outside basis) is adjusted annually for the partner's share of partnership items.
Initial Basis in Partnership Interest
When a partner contributes property to a partnership, the partner's initial basis equals the adjusted basis of the contributed property plus any gain recognized (rare) minus any liabilities assumed by the partnership (net of the partner's share of those liabilities).
Annual Adjustments
The outside basis is adjusted each year as follows:
Increases:
- Partner's share of partnership income (including tax-exempt income)
- Additional contributions
- Increases in the partner's share of partnership liabilities
Decreases:
- Partner's share of partnership losses
- Distributions received from the partnership
- Decreases in the partner's share of partnership liabilities
- Partner's share of nondeductible, noncapital expenditures
Critical rule: A partner cannot deduct losses in excess of the partner's outside basis. Excess losses are suspended and carried forward until basis is restored.
Also remember that a partner's share of partnership recourse and nonrecourse liabilities is included in outside basis. This is a key difference from S corporation basis, where shareholder loans to the corporation create basis but the shareholder's share of corporate liabilities does not.
S Corporation Basis
S corporation shareholder basis works similarly to partnership basis but with an important difference regarding debt:
Initial Basis
The shareholder's initial basis equals the cost of the stock acquired or the basis of property contributed in a Section 351 exchange.
Annual Adjustments
Increases:
- Share of S corp income (including separately stated items)
- Additional stock purchases or capital contributions
- Share of tax-exempt income
Decreases (in a specific order):
- Distributions (nontaxable to the extent of basis)
- Nondeductible, noncapital expenses
- Deductible losses and deductions
Key difference from partnerships: An S corporation shareholder gets basis from direct loans the shareholder makes to the corporation, but does not get basis from third-party loans even if personally guaranteed. In contrast, partners get basis for their share of all partnership liabilities. This distinction is one of the most commonly tested points on the REG section.
Losses first reduce stock basis, then reduce debt basis. When income is earned in later years, debt basis is restored first, then stock basis.
Like-Kind Exchanges (Section 1031)
Section 1031 allows taxpayers to defer gain on the exchange of like-kind real property held for productive use in a trade or business or for investment. After the Tax Cuts and Jobs Act, like-kind exchanges are limited to real property only.
The basis of the property received in a like-kind exchange is:
Basis of property given up - Boot received + Gain recognized + Boot paid
Key rules to remember:
- Gain is recognized to the extent of boot received (but not in excess of the realized gain).
- Losses are never recognized in a like-kind exchange.
- Boot includes cash, non-like-kind property, and net debt relief.
- The exchange must be completed within 180 days (with a 45-day identification period).
Gifted Property
When property is received as a gift, the basis depends on whether the property is later sold at a gain or a loss:
- For determining gain: The donee takes the donor's adjusted basis (carryover basis).
- For determining loss: The donee uses the lesser of the donor's adjusted basis or the FMV at the date of gift.
- If selling price falls between the donor's basis and the FMV at the date of gift (when FMV is lower), there is no gain or loss.
If the donor paid gift tax and the FMV exceeded the donor's basis at the time of the gift, a portion of the gift tax may be added to the donee's basis for purposes of determining gain.
Inherited Property
Property acquired from a decedent generally receives a basis equal to the fair market value at the date of death (or the alternate valuation date if elected). This is commonly called a "stepped-up basis" (or stepped-down, if the FMV is lower than the decedent's adjusted basis).
Key points:
- The holding period for inherited property is automatically long-term, regardless of how long the decedent or the heir actually held the property.
- The step-up in basis eliminates any built-in gain that existed at the time of death.
- The alternate valuation date is six months after death and can only be elected if it decreases both the gross estate and estate tax liability.
Exam Strategies for Basis Questions
- Always start with the acquisition method - How the property was acquired determines the starting basis.
- Track adjustments carefully - Depreciation, improvements, distributions, and income allocations all affect basis. Work through them in order.
- Watch for the partnership vs S corp distinction - Liability treatment is the most commonly tested difference.
- For gifts, consider the dual basis rule - Gain basis and loss basis may differ.
- For inherited property, remember the FMV step-up - This is one of the most straightforward rules in basis.
- Practice the Section 1031 formula - Like-kind exchange basis calculations appear regularly in simulations.
Basis calculations reward methodical thinking. If you follow a consistent approach, even complex scenarios become manageable. Think CPA provides step-by-step practice problems that build your basis calculation skills across all entity types, giving you the repetition and confidence you need to handle these questions on exam day.