Cost Basis: A Guide for the Small Business Owner
Let’s walk through the life of a business asset and discuss why it’s important for business owners to keep track of the basis of each fixed asset they own. We typically don’t calculate the cost basis of a small asset, like a stapler. Instead, we generally keep track of the basis of assets that cost more than $2,500.
First, we’ll get some definitions straight.
Basis is the general term to describe the value of an asset for tax purposes. It includes:
Cost Basis - which refers to the original value of an asset when it is acquired, and
Adjusted Cost Basis – which is the cost basis +/- adjustments due to improvements or depreciation.
The basis of an asset is used to calculate gains or losses upon its disposition. It typically includes the purchase price plus any capitalizable costs, such as acquisition fees, improvements, or expenses related to placing the asset into service. In simpler terms, it’s pretty much what you paid for the item, including extra costs like sales taxes, shipping, installation fees, etc. For example, let say you buy a car for your business. Here’s your invoice:
Purchase price: $30,000
Sales tax: $2,500
Dealer fees: $500
Extended warranty: $1,200
Delivery charges: $300
Total Cost: $34,500
Your cost basis is $34,500 because that’s how much money you paid to acquire the asset. Now here’s the tricky part. Basis can change throughout an asset’s life.
Additions to Basis
If you make improvements that increase the value of your asset, you must add the total cost of those improvements to the basis of your asset. For example, let’s say you bought your car a new engine:
Parts: $8,500
Labor: $1,075
Sales Taxes: $708
Total Cost: $10,283
Now add the $10,283 in improvements to the cost basis of $34,500. Your “adjusted cost basis” is now $44,783. We don’t add the value of routine car repairs such as oil changes to the vehicle’s basis, only major improvements.
Subtractions to Basis
Depreciation is the process of spreading the cost of a tangible asset over its useful life to account for wear and tear, obsolescence, or loss of value as the asset is used in business operations. Each year, rather, each accounting period, you will take depreciation, which shows as a non-cash deduction on your P&L, for your business’s fixed assets. No depreciation for personal assets! As you depreciate each asset over time, you will need to subtract the asset’s accumulated depreciation as a subtraction to its cost basis. Tax accountants should prepare a document called a “depreciation schedule” each year to help you keep track of depreciation. Yes, depreciation is a complex topic to be saved for another exciting blog.
We’re going to keep things simple and just assume that the car will be depreciated $4,478 in its first year. How we came up with that number will be answered in another blog post. Nonetheless, we need to subtract it from our adjusted cost basis: $44,783 - $4,478 = $40,305 is now the new adjusted cost basis. And we will keep subtracting depreciation each year the asset is in service.
Disposition is the final part of the life cycle of an asset. For most cases, disposition just means selling the asset. Let’s say we find a buyer to buy your car for $40,000 flat. To calculate the gain or loss on the disposition of an asset, you take the selling price and subtract the adjusted cost basis. So, $40,000 - $40,305 = ($305). Because that’s a negative number, it is called a loss, not a gain. It’s not taxable, and it will offset (or reduce) ordinary business income. That is why it is necessary to keep track of each asset’s basis.
In summary, the rules for figuring out the cost basis can depend on how you got the asset — whether you bought it, received it as a gift, or inherited it. Knowing your basis is important because it helps you figure out how much tax you might owe when you sell it. It also helps you determine how much of a tax deduction you can take each year for depreciation.
Types of assets you need to keep track of basis for:
Stocks
Option contracts
Cryptocurrency
Vehicles
Real Estate
Collectibles
Computers
Plant, Property, & Equipment
Office furniture
Machinery
Not every asset is depreciable. Only tangible business assets with a useful life greater than 1 year are depreciable. Personal assets, land, and inventory do not depreciate. I hope this helps you understand basis.