The story of basis.

• Author: Sullivan, Jeanne

Basis is a beneficial concept for a taxpayer--it shields the taxpayer from tax on the sale of an asset and can produce losses that reduce tax liability. It has been described as a "summary of the tax impact of [past] events" that have affected an asset. (1) Nevertheless, basis can be elusive: It can appear or disappear when we are not paying attention. (2) It can cling to an asset, be adjusted up or down, replicate itself, or shift to another asset. In other words, the summary that basis provides can have a number of potential twists and turns.

This article explains some of the basics of basis and one of the subplots in the general story it tells, using the following situation:

Example 1: A has decided to invest in real estate, so she takes funds that she has recently inherited ($400x) and buys a 20% interest in land. The seller is looking for a buyer for the other 80% of his real estate. A will have a cost basis in her 20% interest in the real estate. Although there is no all-purpose definition of basis for tax purposes, according to Sec. 1012 the basis of property is its cost, except as otherwise provided. There does not appear to be any issue associated with determining A's basis in her 20% interest in the land after she buys it. If she were to sell the 20% interest in the r land, she would be able to get back her $400x without tax consequences; her basis in the 20% interest reflects the amount she paid for the land.

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The underlying principle of basis determinations is expressed by the general meaning of the word "basis": "a relation that provides the foundation for something ... the fundamental assumptions from which something is begun or developed or calculated or explained."' Under the federal tax laws, that fundamental assumption or foundation is the measurement or amount that the owner of property is treated as having invested in the asset, the amount that the taxpayer can withdraw or receive from the property without realizing income or gain from the property. As a result, to the extent basis includes untaxed dollars, basis determinations can provide the foundation for a tax shelter, allowing taxpayers to receive what some may perceive to be excessive tax benefits. From another perspective, as long as basis accurately tracks what is defined as the taxpayer's economic investment in property, it is performing its function appropriately.

Basis from Proceeds of Debt

Under a traditional balance sheet approach to wealth, if both the asset and liability sides of the balance sheet increase equally, there is no net increase in net worth. Thus, incurring debt does not increase a taxpayer's net worth; the cash received as debt proceeds is exactly offset by a liability to repay the debt. Because under our income tax system a taxpayer must "realize" income or gain before tax is imposed, borrowing money does not have immediate tax consequences. Borrowed cash is full basis, untaxed money in the borrower's hands. These funds may be used to purchase assets with a full cost basis that enable the taxpayer to earn profits and suffer losses in operating or disposing of the assets. (4) If the debt is genuine and reasonable in terms of the fair market value (FMV) of the purchased property, the full amount of borrowed funds generally gives rise to cost basis. (5)

Example 2: A wants to get started building on her land, but the seller has not been able to find a buyer for the rest of the land parcel. A discusses this with her banker, who suggests that she could borrow enough money to buy the seller's entire parcel. Because A is risk averse, the banker suggests that she borrow the funds on the security of the purchased real estate, without any personal obligation to repay the debt. A is intrigued by the possibility of obtaining money to make the investment and not being personally obligated to repay the loan. The banker is suggesting that A borrow on a nonrecourse basis. Generally, nonrecourse debt is debt for which the lender has no recourse against the borrower personally, and the lender can proceed against the security for the loan only if the borrower defaults. Debt for which the borrower has personal liability is termed recourse debt.

Recourse and Nonrecourse Debt in Crane and Tufts

The tax treatment of recourse debt generally has been clear: The obligor has full basis in cash or property acquired with recourse debt and, if a buyer assumes, or takes the property subject to, a mortgage for which the seller is personally liable, the full amount of the recourse debt is included in the seller's amount realized. Because the buyer is treated as satisfying a personal obligation of the seller, under the principles established in Old Colony Trust Co. and Hendler, (6) the seller has income equal to the amount of the obligation satisfied. As a result, the tax treatment of recourse debt is not controversial: The borrower has full basis in assets acquired with recourse debt, and the amount realized on the sale of the asset subject to the debt includes the full amount of the debt. Because there is no personal liability for nonrecourse debt, however, the buyer who assumes (or takes subject to) nonrecourse debt is not satisfying an obligation of the seller. Thus, the proper tax treatment of nonrecourse debt both for basis purposes and to determine the amount realized on the sale was originally uncertain.

The Supreme Court established favorable tax treatment of nonrecourse debt in Crane. (7) In that case, Mrs. Crane inherited a mortgaged apartment building and lot from her husband. The property had an appraised value equal to the mortgage. Mrs. Crane operated the building, collected the rents, paid for operating expenses and taxes, and paid the net amount to the lender for seven years. She reported the gross rentals as income and claimed expenses for taxes, operating expenses, depreciation, and interest on the mortgage. On November 29, 1938, with foreclosure looming, Mrs. Crane sold the property to a third party for $3,000 in cash, subject to the mortgage, and paid $500 in sale expenses. For tax purposes...