Study Unit 6: Basis and Property Transactions

Mike purchased a building lot in Year 1 for $25,000 and constructed his primary residence there for an additional $175,000. In Year 4, Mike moved to a different city but kept the house he constructed in Year 1 and converted it to a rental property. On the date Mike made this change, the fair market value of the converted property was $225,000. For depreciation purposes, what is Mike’s basis in this rental property?

• $150,000

• $175,000

• $200,000

• $225,000

Answer explanation

Property converted into business use uses a basis of the lesser of the FMV of the property at the conversion date [$200,000 ($225,000 – $25,000 land)] or the adjusted basis at conversion [$175,000 (land is excluded for the depreciation basis)]. Because Mike’s adjusted basis is less than the FMV at the date of conversion, the adjusted basis is used.

Arthur is a proprietor of Arthur’s Pizza Emporium. He bought a commercial building several years ago. He made a down payment of $20,000 in cash and assumed a mortgage for $100,000. After he paid off the mortgage, Arthur later sold the building for $180,000. Straight-line depreciation taken up to the date of sale was $18,000. What is the total gain on the sale?

• $78,000

• $80,000

• $60,000

• $160,000

Answer explanation

The adjusted basis of property is typically the cost basis increased by certain items, such as boot given. The cost basis for the commercial building is the $20,000 down payment of cash by Arthur, increased by the assumption of the $100,000 mortgage. Therefore, Arthur’s basis in the commercial building is $120,000. However, this basis is reduced by the $18,000 of depreciation taken. When Arthur sells the commercial building for $180,000, he must recognize a gain on the difference between the amount realized of $180,000 and his adjusted basis of $102,000 ($120,000 basis – $18,000 depreciation) for a total of $78,000.

Amounts paid or incurred to demolish a structure are

• Deductible as a casualty loss.

• Capitalized and amortized over a 180-month period.

• Treated as a reduction of the basis of the structure.

• Capitalized and added to the basis of the land where the demolished structure was located.

Answer explanation

Initial basis is adjusted consistent with tax-relevant events. An adjustment is made for demolition of a structure. Costs and losses associated with demolishing a structure are allocated to the land. The costs include the adjusted basis (not FMV) of the structure and demolition costs.

John purchased a new electric automobile on July 2, 2015, for $18,000. He also claimed a $2,000 plug-in electric drive motor vehicle credit on his 2015 tax return for that vehicle. From 2015 through 2022, John used this automobile only for personal purposes. On January 1, 2023, he began using the electric automobile exclusively for business purposes. The fair market value of the automobile on that day was $17,000. What is the automobile’s depreciable basis as of January 1, 2023?

• $15,000

• $16,000

• $17,000

• $18,000

Answer explanation

Basis for depreciation is the lesser of the FMV of the property at the conversion date or the adjusted basis at conversion. The FMV on the date of conversion was $17,000. The basis was $16,000 ($18,000 purchase price – $2,000 deduction). Thus, the basis equals $16,000.

Bob purchased a building and land to use in his business for a price of $1,000,000. The land was valued at $300,000 (included in the price). He then incurred $90,000 to replace the roof of the building. The city replaced the sewage lines to his business and assessed Bob $20,000. Bob had been slow in getting insurance coverage on the real property and incurred a small fire loss of $10,000, which he plans to deduct on his business tax return. What is Bob’s basis for depreciation after deducting the loss?

• $1,100,000

• $810,000

• $800,000

• $720,000

Answer explanation

To determine the basis of the building for depreciation, the value of the land ($300,000) must be subtracted from the total purchase price of $1,000,000 to get $700,000. The $90,000 spent to replace the roof and the $20,000 spent to replace the sewage lines must be capitalized because they are capital expenditures, and they increase the value of the property. The $10,000 fire loss should reduce the basis because casualty losses reduce the basis by the amount of the loss. The total depreciation basis equals $800,000 ($700,000 + $90,000 + $20,000 – $10,000).

Which of the following activities would subject a taxpayer to the uniform capitalization rules?

• Taxpayer produces real or tangible property for non-business use.

• Taxpayer acquires property not for resale.

• Taxpayer produces real or tangible personal property for sale to customers and average annual gross receipts exceed $29 million.

• None of the answers are correct.

Answer explanation

Under Sec. 263A(b)(1), the uniform capitalization rules apply to real or tangible personal property produced by the taxpayer if average annual gross receipts exceed $29 million. Property produced for the taxpayer’s own use is excepted, unless the use is in a trade or business or an activity conducted for profit [Sec. 263A(c)(1)]. In addition, the taxpayer is subject to the rules if property is acquired for resale (unless the property is personal property and average annual gross receipts are $29 million or less).

Several years ago, you paid $150,000 to build your home on a lot that cost you $50,000. Before converting the property to rental use last year, you paid $30,000 for permanent improvements to the house. You received a $5,000 easement payment from the State of California for use of the land for a power line. The county indicates the FMV of the house is $250,000 and the land is $100,000. What is your basis for depreciation?

• $150,000

• $175,000

• $180,000

• $250,000

Answer explanation

For property converted into business use, the basis for depreciation is the lesser of the FMV of the property at the conversion date or the adjusted basis at conversion. The adjusted basis in the house on the date of conversion is $180,000 ($150,000 + $30,000). The FMV of the house on the date of conversion is $250,000. Accordingly, the depreciable basis for the house is $180,000. The $5,000 easement is related to the land, which is not depreciated (Publication 551).

Larry purchased an office building and land on February 1 of the current year for $1,000,000. No liabilities were assumed. The assessed value of the assets for real estate purposes at the time of the purchase were as follows:

Assessed Value

Land $300,000

Building   500,000

What is the basis of the building?

• $500,000

• $600,000

• $625,000

• $700,000

P&L Partnership purchased a building for commercial purposes on July 1 for $200,000. Carpeting was installed at a cost of $8,000 on August 30. Furniture was purchased at a cost of $10,000 on September 1. Legal fees of $700 and recording fees of $100 were incurred at the time the building was purchased. What is the cost basis of the building?

• $218,800

• $200,000

• $200,800

• $218,000

Answer explanation

Cost basis is the sum of capitalized acquisition costs. Capitalized acquisition costs include purchase price, closing costs, major improvements, and miscellaneous costs, e.g., freight. Examples of closing costs are legal fees and recording fees. The carpet and the furniture are newly acquired assets and must be capitalized separate from the building.

Dianne’s Desserts, a sole proprietorship, bought a building for $350,000 cash in January. Settlement costs were $12,500. The business placed $15,000 in escrow for future payment on taxes and insurance and assumed an existing mortgage of $20,000 on the property. Legal fees of $7,500 were incurred for defending and perfecting title in a lawsuit that occurred during the same year. What is the adjusted basis of the building on December 31?

• $390,000

• $405,000

• $385,000

• $377,500

Answer explanation

The basis of the property purchased can include settlement fees and closing costs for purchasing the property. Some settlement fees and closing costs that are specifically included are abstract fees, legal fees, transfer taxes, and any amounts that the seller owes that you agree to pay. Settlement costs do not include amounts placed in escrow for the future payment of items, such as taxes and insurance (Publication 551). Thus, the adjusted basis of the building equals $390,000 ($350,000 cash paid + $12,500 in settlement costs + $7,500 in legal fees + $20,000 mortgage assumed).