Study Unit 9: Property Transactions: Basis and Dispositions

Mr. Rabbitt purchased a home for $200,000. He incurred the following additional expenses:

1. • $200 fire insurance premiums

2. • $500 mortgage insurance premiums

3. • $400 recording fees

4. • $250 owner’s title insurance

Compute his basis in the property.

• 
  $201,350

• 
  $200,000

• 
  $200,650

• $201,150

Answer explanation

When a taxpayer purchases property, his or her basis in the property is initially cost. Cost basis is the sum of capitalized acquisition costs. Initial basis in purchased property is the cost of acquiring it. Only capital costs are included. One component of capital costs is closing costs, which include brokerage commissions, prepurchase taxes, sales tax on purchase, title transfer taxes, title insurance, recording fees, attorney fees, and document review preparation. Expenses not properly chargeable to a capital account include costs of maintaining and operating the property (e.g., interest on credit related to the property), insurance (e.g., casualty), and ordinary maintenance or repairs (e.g., painting). Mr. Rabbitt should include the cost of the home ($200,000), the recording fees ($400), and the cost of the owner’s title insurance ($250) in the basis of his new home. Thus, his basis in his new home is $200,650 ($200,000 cost of home + $400 recording fees + $250 title insurance).

You incurred the following expenditures in connection with your rental property. Which of them should be capitalized?

• 
  New roof.

• 
  Install new cabinets.

• 
  Pave driveway.

• All of the answers are correct.

Answer explanation

Generally, expenses that add to the value of the property, substantially prolong the useful life of the property, or adapt the property to a new or different use are considered capital expenditures and are not currently deductible. Thus, capital expenditures include the cost of acquiring or constructing buildings, machinery, equipment, furniture, and any similar property that has a useful life that extends substantially beyond the end of the tax year. Maintenance and repair expenditures that only keep an asset in a normal operating condition are deductible if they do not increase the value or prolong the useful life of the asset. Installing a new roof, installing new cabinets, and paving a driveway are all major improvements that add to the value of the property.

Mr. Ng, sole proprietor of Wu Company, purchased a machine for use in his business. Mr. Ng’s costs in connection with its purchase were

as follows:

Cash paid to seller $  4,000

Note to seller 48,000

State sales tax 2,600

Ordinary machine repairs 800

Wage expense to install machine 3,200

What is the amount of Mr. Ng’s basis in the machine?

• $54,600

• $55,200

• 
  $58,600

• $57,800

Answer explanation

Under Sec. 1012, the basis of property is the cost of the property. Sales tax paid in connection with the acquisition of property is treated as a cost of the property [Sec. 164(a)]. Installation and testing charges are also included as part of the cost of the property. However, the ordinary maintenance and repair costs are expensed instead of capitalized to basis. Basis is computed as follows:

Purchase price $52,000

Sales tax 2,600

Installation and testing charges 3,200

Basis in equipment $57,800

Ed purchased a house on an acre of land from Ruth on June 30, 2022. Prior to the purchase, Ed had been renting the house from Ruth for $500 per month. Ed paid the following amounts:

1. • $100,000 in loan proceeds to Ruth

2. • $2,000 in points to the bank

3. • $1,000 in real estate taxes Ruth owed to the town

4. • $1,000 in past-due rent to Ruth

5. • $1,000 in closing costs to the bank for legal, recording, title insurance, and survey fees

6. • $1,000 in escrowed real estate taxes to the bank

What is Ed’s basis in the house and land purchased from Ruth?

• $100,000

• 
  $102,000

• 
  $104,000

• $106,000

Answer explanation

Initial basis in purchased property is the cost of acquiring it. Only capital costs are included, i.e., those for acquisition, title acquisition, and major improvements. Ed would include the loan proceeds to Ruth; the amount paid for real estate taxes Ruth owed to the town; and closing costs to the bank for legal, recording, title insurance, and survey fees. Thus, Ed’s basis in the house would equal $102,000 ($100,000 loan proceeds + $1,000 real estate taxes owed by Ruth + $1,000 closing costs).

Rick, an electrician, needed a new service van. He was a frequent customer of Eldon’s Grill. Eldon wanted to remodel his kitchen. Eldon offered to sell his catering van, fair market value $10,000, to Rick for $8,000 and pay $1,000 cash in return for Rick’s rewiring his kitchen. If Rick agrees to do the work under these terms, what will be his basis in the van received?

• 
  $10,000

• 
  $11,000

• $8,000

• $9,000

Answer explanation

When property or services are exchanged between parties, it is considered bartering. Bartered services or goods are included in gross income at the fair market value of the item(s) received in exchange for the services. If the parties have agreed prior to the exchange what the value of the services is, that value will be considered the fair value. Rick has traded his services for $1,000 cash and the opportunity to purchase a van with an FMV of $10,000 for only $8,000. The basis of the van is $10,000 to Rick, and he reports $3,000 of income for his services provided.

The basis of property acquired by purchase includes all of the following EXCEPT

• Amount paid in notes to the seller.

• 
  Freight, installation, and testing charges.

• Unstated interest on any time-payment plan.

• 
  Sales tax charged on the purchase.

Answer explanation

The basis of purchased property does not include unstated interest on time-payment plans. Interest is deductible as an expense.

Taxpayer J purchased a business building with a fair market value of $60,000 and a business auto with a fair market value of $10,000. Both were acquired in a bargain purchase for a total cost of $49,000. What is the basis of the auto?

• 
  $5,000

• $7,000

• 
  $10,000

• 
  $49,000

Answer explanation

The basis of property is defined in Sec. 1012 as its cost. When several assets are purchased for a lump sum, the basis of each asset is determined by allocating the total cost based on the relative fair market value of each asset. The basis of the auto is computed as the fair market value of the individual asset over the fair market value of all the assets times the total cost.

$10,000 x $49,000 = $7,000

$70,000

Mr. T purchased an apartment building on December 15 of the current year. Mr. T’s costs in connection with the purchase were as follows:

Cash paid to seller $25,000

Secured notes to seller 55,000

Assumed an existing mortgage on the property 15,000

Sales commission paid to broker 3,000

Transfer taxes 600

Paid back taxes owed by seller 700

Paid interest on mortgage from date of purchase to end of December 100

What is the amount of Mr. T’s basis in the building?

• 
  $80,000

• 
  $95,600

• $99,300

• 
  $99,400

Answer explanation

The basis of property is its original cost (Sec. 1012), reduced by allowable depreciation [Sec. 1016(a)(2)]. The cost of property includes debt to which the property is subject (Crane, 331 U.S. 1, 1947). Consequently, the basis of the property includes the cash paid, any notes to the seller, and the liability to which the property was subject. Closing costs such as commissions paid to a broker are also included as part of the purchase cost. Taxes paid by a buyer that were not the legal responsibility of the buyer are also allocated to the purchase price (they are not deductible under Sec. 164). Mortgage interest paid is deductible under Sec. 163 (not included in cost). Mr. T’s basis in the building is

Cash$25,000

Secured notes 55,000

Mortgage 15,000

Sales commission 3,000

Transfer taxes 600

Seller’s taxes 700

99,300

Mr. Taylor, sole proprietor of Taylor Company, purchased a machine for use in his business. Mr. Taylor’s costs in connection with this purchase were as follows:

Note to seller $90,000

Cash paid to seller 7,500

State sales tax 4,875

Freight charges to place of business 1,500

Wages paid to install machine 6,000

What is the amount of Mr. Taylor’s basis in the machine?

• $109,875

• 
  $108,375

• 
  $108,375

• 
  $103,875

Answer explanation

Under Sec. 1012, the basis of property is the cost of the property. Sales tax paid in connection with the acquisition of property is treated as a cost of the property [Sec. 164(a)]. Delivery, installation, and testing charges are also included as part of the cost of the property. Basis is computed as follows:

Purchase price $  97,500

Sales tax 4,875

Delivery charges 1,500

Installation and testing charges 6,000

Basis in equipment $109,875

Beth and Donnie purchased a house to use as rental property. They paid the following amounts: $100,000 cash, assumption of an existing $25,000 mortgage, $500 title search, recording fees of $100, points for their new loan of $1,000, and the seller’s part of the property taxes of $1,500. The seller did not reimburse them for the property taxes. What is their cost basis in the house?

• 
  $100,000

• 
  $100,000

• 
  $127,100

• 
  $128,100

Answer explanation

When a taxpayer acquires property, his or her basis in the property is initially cost, substituted, transferred, or exchanged basis. Cost basis is the sum of capitalized acquisition costs or the costs of acquiring the property. Only capital costs are included with some of the more common capital costs being recording fees, title search costs, cash, and the assumption of a mortgage. Property taxes paid on behalf of the seller are also considered a cost in acquiring the property. Points paid by the borrower with respect to a home mortgage are prepaid interest and are typically deductible over the term of the loan.

Basis:

Cash $100,000

Assumption of mortgage 25,000

Title search 500

Recording fees 100

Property taxes - sellers 1,500

Cost basis in house $127,100