I've been asked by a few readers to do a deep dive on "basis" - and never one to shy away from nerd-level content 🤓, what follows is as good as I've got.

But what should be said first is that entire careers can be built on basis-specific and basis-adjacent niches. So this can't begin to touch on all the nuance and fringe cases. 🫨 But we can get to a really good grasp of what it is, isn't, and why it should matter.

Let's dive in.

We'll cover the below and hopefully come out better for having read it (maybe a few times):

1. What is basis?
2. What are the different types of basis?
3. How does basis change between entities?
4. Why is basis important to understand for investors and business owners?
5. What are some clever ways basis is used in tax planning?

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What is Basis?

The simplest definition I have is that basis is the amount of investment a taxpayer has made in an asset. 💰

The best way to convey this basic definition is that basis is used to calculate gain when an investment is sold. 🧮 For example, if I buy 1 share of stock for $100 - that is my basis in that stock. If I later sell that stock for $105, the taxable gain is calculated as the proceeds ($105) less my basis ($100) = $5 taxable gain.

I do not get taxed on the $100 of the original purchase price, as presumably I've already paid tax on that money - and that would be double taxation. ✌️

Now that we get that, it's important to understand that depending on the type of asset we make the investment in, our basis may change over time as a result of various events - such as: additional investment, distributions, and allocations of income or loss. ⌛

Let's do another example but this time we buy a $100 sewing machine that will be used to sell blankets. 🧵 My basis in the sewing machine starts out as $100. But in doing my taxes, to offset the sales I earn, I'm allowed to take a depreciation deduction of $20 for one year. This $20 in depreciation deduction reduces my basis in this sewing machine to $80. So my adjusted basis in the sewing machine is now $80. 🔻

And one step further, let's say instead of buying the $100 sewing machine myself, I instead fund an LLC partnership with my friend (50/50) with that $100. And the LLC partnership records net taxable income of $1,000 and distributes $250 of profit to me. In this case, I didn't buy a sewing machine - I bought a partnership interest. So my adjusted basis is now $100 original investment + $500 (50% of $1,000) - $250 (distributions made to me) = $350. And my K1 would say $500 of income that I would pay tax on. 🤷‍♂️

An important concept in understanding basis is clarifying what s being purchased and by whom.

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What are the Different Types of Basis?

If you don't make investments in, or provide services to, private investments (SMBs, real estate), then you can probably skip to the last section ⏩ - as we're about to get deep into SMB and private real estate topics.

Tax Basis

I think of tax basis as the amount of investment made into an asset with "already-taxed" dollars.

It is wholly possible for an investor to control and access to "pre-tax" dollars for which he has no tax basis in - a 401(k) account is a great example. Because you have not paid federal income tax on the investments in your 401(k) plan, you have no tax basis in them. 🙅‍♂️ You have basis and may even exert significant control over them - but you do not have tax basis in the balance until tax is paid on it.

Similarly, to the extent that adjustments are made to your tax basis with tax-related items - your tax basis will change. So when my LLC partnership gives me a K1 with a $500 taxable income amount on it, because I will pay tax on the $500, my tax basis increases (see the calculation above). 🆗

An excellent example I will cover in the last section is an Opportunity Zone investment. 🏚️ Because the tax on these gains has been deferred, the taxpayers making these investments have no tax basis in those real estate investments. They have basis in them, but not tax basis - so the income tax impacts must carefully tracked so as not to run afoul of various tax rules (especially around losses and distributions).

Adjusted Basis

While referred to already above, adjusted basis represents the amount of current basis a taxpayer has in an asset after allowing for all additions, distributions, income, or loss to or from the asset. ➕➖✖️➗ It's worth specifying here that basis can be referred to as both: (a) the amount paid to a partnership as an investor, and (b) the amount paid by the partnership for an asset. 💆‍♂️

So an investor will have an adjusted basis in the partnership and the partnership will in turn have an adjusted basis in it's assets purchased. Partnership investments are adjusted for what we referred to above (additional contributions, distributions, income or loss allocated). While the underlying assets basis are generally only adjusted down for depreciation.

The basis of all investors should equal the underlying basis of the partnership in it's assets - until it doesn't, which we'll cover too. ⚖️

Debt Basis

I'll cover more on this in the below section, but debt basis represents additions to the basis of an investment made in an asset with loan proceeds. 🏦 This is a really important concept to understand as it relates to entity selection impacts on tax structuring.

Not all taxable entity types allow for debt basis for investors - and the general rule in tax is that you want your basis as high as possible because of the calculation we did at the start 🔺 - where you get to subtract your basis from any proceeds of a sale.

Deeper into the debt basis rules are even more nuance of "classifications" of types of debt - recourse, non-recourse, and qualified non-recourse. If you want a primer on these different types of debt and how they impact investors, click here for another post I recently did.

But a relevant side bar here is about what basis ISN'T. 👉 Basis is not capital. 👈 Both of those words are very specific in the tax code and each has different implications on tax returns. Capital is the cash (or property) you contribute to the business. Basis includes this capital but also includes debt (for partnerships) AND other outside basis increases.

Inside Basis

Know how I said there are two types of "basis" we'll make reference to? ✌️ What an investor paid for his partnership interest and then what that partnership paid for the underlying assets? The tax code labels the latter (what a partnership has paid for the underlying assets) Inside Basis.

I think of inside basis most like "book basis" of the underlying assets. 📖

For example, let's say a partnership is formed with $200 of cash. It then uses that $200 of cash to buy sewing machines for $200. Those sewing machines earn $1,000 of profits, of which $500 is paid out. This leaves the inside basis of the partners equity as $200 + $1,000 - $500 = $700.

The balance sheet of the company would look like this (yes, ignoring depreciation):

Outside Basis

Okay - now for outside basis. This is the amount the partner has paid for the investment in the partnership. 💰 And in our above sewing example, outside basis starts out innocently enough as also the same amount as inside basis.

But this gets complicated when a third partner, using our same example, wants to get in on the sewing machine cash cow. 🤑 Whereas the original two investors paid only $100 each for their 50% interest, they now how a customer list and process which drove the profitable year. So they decide the fair value (or enterprise value) of the sewing machine partnership is now $2,000.

So if new partner wants 20% of the ownership, she will have to pay $400 (20% x $2,000). This $400 is the new partners outside basis - or what she paid for the partnership interest. It will also get adjusted up or down for additional contributions, distributions, income, or loss allocated to her - just like basis does for everyone.

But wait - the astute reader will look at the Inside Basis calculation and see a problem. 😠 The inside basis of the partnership is only $700. So 20% of that inside basis is $140 - meaning the new partner paid $400 for inside basis of $140. Did she get ripped off? Nah. 😅

When partnership interests change hands, there can often be this kind of disparity in inside and outside basis. And in the right entity, this disparity can create unique tax opportunities for the new partner (a 754 step-up). But let's look at how that changes between entities.

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How Does Basis Change Between Entities

The tax code is best likened to ancient sewer systems under major cities. 🌇 It started out simply a hundred years ago, was fixed where found broken, expanded to adapt to overuse, and the rest of the joke makes itself. 💩

But this evolutionary process explains why different types of entities enjoy different benefits and draw backs of various tax impacts - two of which is the ability to utilize things like debt basis and basis adjustments.

Individual 👨

If I, or through a disregarded entity like a single member LLC, decide to buy a rental home with a mortgage, my basis is the down payment plus the amount of the mortgage. This means that individuals enjoy the ability to utilize debt basis when determining the amount of income or loss and taxability of distributions from this kind of investment.

As a single owner, I'd never encounter a scenario where I allowed outside investors into my rental - as then it would become a multi-member LLC and fall into one of the below or other categories of tax entities. So an individual would never have a basis adjustment like a 754 step-up.

Partnership 👬

A Partnership, however, is a totally different ball game. Partnerships are the ideal entity choice for regularly incoming and exiting partners, appreciating property, or property financed with debt.

Partnerships, unlike S-Corps as we'll see below, allow for an increase in basis from debt. This allows partners to take additional distributions with minimal tax impact and take more in losses that are financed with debt when compared to S-Corps. Check out the previously linked email for how things like "at-risk" impact the ability to take losses at the personal tax level.

Also unique to Partnerships is the ability of an income partner (the third partner in our sewing machine venture example) to "step-up" their basis in the inherited "inside basis" assets. This allows the new partner to receive additional deductions of (usually) depreciation over the life of those underlying assets. Worth nothing that this cuts both ways. If a new partner buys into an asset that has "substantially decreased in value" that a step-down may be required with opposite impacts to partners - but that's a whole other topic.

S-Corp 🙇‍♂️

S-Corps are the least flexible of pass-through entities - mainly because they are akin to an afterthought split off of the sewage system that is C-Corps. Because of that, they are much worse entity choices for the fact pattern that makes a partnership a good choice (debt, appreciating assets, debt).

S-Corp shareholders do not get additional basis for debt within the S-corp - except their own personal shareholder loans. That means distributions in excess of basis happen much sooner than partnerships when debt is involved - creating taxable distributions often unexpectedly.

Also, new shareholders do not get an option to step-up their basis in the assets of the S-Corp no matter how much the difference in outside to inside basis is.

These reasons make S-Corps and real estate generally a very bad combination.

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Why Basis is Important for Investors and Business Owners

Understanding what will happen over the lifecycle of a business is critical to entity selection. But that's not the only reason for business owners and investors to understand their basis. A couple other ways that basis can play an important role in tax planning:

Gain / Loss / Character

Phantom income can happen very easily when basis has been decreased through losses allocated to an investor. 👻 When K1s are issued after an asset has been sold, they will often disregard the decreases in basis from those losses and not understand how they should have received any "gain" when they got no distributions ever and "lost" all their equity. That is a common occurrence when partnerships are financed with debt and generate outsized losses.

It's also how recaptured gain can bite back. 🐕‍🦺 If the basis was reduced by losses from depreciation on a property that is later sold at a higher than original purchase price, the amount of previously allocated depreciation is "recaptured" at (mostly) the same ordinary tax rate as the depreciation deduction. This can hurt if the investor was planning on capital gains treatment and gets hit instead with a large amount of recaptured ordinary income.

Who Will Get the Loss

Which partners will get losses allocated to them when the losses are financed with debt is also poorly understood. 🤕 I did a deep dive here on how to figure how much loss you will get as an investor in a real estate investment. But in short, you need to understand the type of debt that the partnership has (guaranteed or non-recourse) to best predict who will get losses first and last.

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Clever Ways to Use Basis in Tax Planning

Schnikes. We're in for over 2,000 words already and you've likely not made it this far on your first read unless (a) you're as into this stuff as I am, or (b) you skipped all the SMB / real estate specific stuff. 😮‍💨

So let's land this plane and talk through some clever ways basis is used in tax strategies.

Opportunity Zones

Opportunity Zones initially had a two-fold tax benefit: (1) deferral on the tax on capital gain (which now is only another year - but was much more attractive in 2018), and (2) a full-step up in basis when sold after being held in the Qualified Opportunity Zone Fund for more than 10 years. It's this step-up that is the real magic. 🧙

Whereas if the OZ property was held in a regular partnership, the sales proceeds would be applied against the adjusted basis of the property to calculate a gain (some capital but some also recaptured - in a qualified OZ Fund held for enough time, that gain (including recapture) is GONE. The magical step-up means that the adjusted basis is equal to the sales price and avoids all tax on it. 🤯

1031

Qualifying 1031 transactions work in almost the opposite way. They keep the old basis for sold property and "roll it" into a new property while deferring the otherwise taxable gain. This is just gain deferral - but is very much the real estate professionals 401(k) account. 😉 The deferred gains allow for more compounding that will later be taxed when eventually sold and not 1031'd.

Estate Step-up

Inherited property at the time of death is also permitted a step-up in basis to fair market value. ⚰️ This means that gain on inherited property can be avoided altogether when planned for properly. The recipient of the inherited property isn't taxed on the value of property received and if turned around and sold, gets to use the higher basis as the amount to reduce the sales price against before paying taxes.

Estate and gifting is an entirely different beast with different rules 🧟 - so always talk to a professional about specific questions here.

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And I'm spent. We covered a lot of ground, but as noted at the top this is a topic we can spend careers in learning nuances. Basis remains a critical input to understanding your business, investment, and tax options - so I hope this was helpful. 🤞

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