 Hello and welcome to the session in which we learn about how to compute the basis of property. Specifically, we're going to be looking at two types of methods of acquiring property and that's a regular purchase or acquisition and an exchange for services provided. Let's go ahead and start with property received for services. And what does that mean? Simply put, you want to buy an asset and you don't have the money to pay for it. What you can do is you can provide some sort of a service to the seller and the seller will give you the asset after you have to provide after you provided the service. For example, you will you would paint their business, you will mow their lawn, you will fix their computers, you will provide the service and in exchange they will give you this asset. So, a taxpayer may be receiving property in exchange for services provided to another party. The initial basis of the property received in exchange for services provided is the fair value of that property. That's one way to look at it. However, if I agree with the seller about a price for my services up front, so I'll tell the seller, look, I will do this work for you, I will paint your business and I want five thousand dollars. Then guess what? So, if the price of the services performed was agreed on beforehand, so that's the deal, that the price is considered to be equal to the fair value of the property and you gave me some sort of a property, inventory, a computer, whatever you gave me, if I told you my services are worth five thousand, it means the asset that you gave me is worth five thousand, unless there is contradictory evidence to that deal. Okay, so this is how we determine this. Now, the holding period of a property received for services, when does it start? Because we know when it's important, is when the property is received. So, let's take a look at an example to illustrate this concept. John, a civil engineer, planned, designed and ever saw the construction of a building structure for ABC Company. On March 12th, 20X1, after the job was completed, John accepted property with the fair value of 20,000 for all the work he performed. So, there was no deal. In other words, John did not agree on a price for his work. Simply put, once the work is done, they accepted a property. I don't know what that property is, maybe a small piece of land. It happens to have a $20,000 fair value. Guess what? That piece of land is worth $20,000 because that's the fair value of the property and John's services are worth $20,000 because we assume the exchange between John and ABC Company is between two rational people. So, if John accepted a fair value of an asset of $20,000, it means his work was worth $20,000. So, as a result, John's basis for the property received equal to $20,000. In his period, his holding period begins March 12th, 20X1. So, that's the property received for services. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Let's look for property purchased. Property purchased simply put, you went to a business and you purchased the property. You paid for it. When a property is purchased by a taxpayer, the cost basis of the property include but not limited to the following item. Usually, it's the purchase price. That's usually the largest piece of the puzzle, at least when you pay for something. If you pay for shipping that's included, because think about it, if you buy something and you don't pay for its shipment, you don't have it. So, you don't have it ready for its intended use unless you pay for the shipment. Also, you might have to pay for sales tax. Well, sales tax, same concept. You might have to pay for sales tax. If you don't pay for sales taxes, they won't sell it to you. Freight in, which is basically the same as shipping cost. Installation and testing. So, if you have to install this asset, test this asset, test this property, it's not ready for its intended use. It gets added to the basis. If you incurred any legal fees to acquire the property, you hired a lawyer to have the paperwork closed. Any excise taxes, excise taxes, if you bought it from overseas and you have to pay taxes to import it into the country, revenue stamps, basically the same concept. If you have to pay a recording fee to put that property into your name to make it official, all of those are added to the cost of the property. On the other hand, the holding period begins on the date the property is acquired. Now, of course, we will have to look at an example just to kind of see how it works. On February 15, Emily acquired machinery from Joseph. The machinery had a purchase price of 8100. Emily incurred shipping cost. Emily, she needs to ship the property. Otherwise, she don't have it for 750 to bring the property to its premise. An installation cost of 320. Determine the basis of the machinery. Well, guess what? It's 9,170 computed as follow. The 8100, the purchase price, again, that's usually the largest component of the cost. The shipping cost and installation cost. And obviously, the property holding period will start February 15, 20x3, when Emily acquired this machinery. Now, sometimes what we have to do is basis allocation, allocate the basis between several assets. If a taxpayer buys a land with an attached building for a lump sum, this is called sometime lump sum purchase. Under those circumstances, here's what happened. You paid one price, let's assume $100,000 for something. You bought the land and you bought the building. You did not buy them separately. You bought two different assets and sometime you buy three different assets or four different assets all at the same time. What's going to happen under those circumstances? You must allocate the cost among the land, the building according to their respective fair market value. Sometime in financial accounting, we call it relative fair value. As such, the basis of the land will be determined as follow. We'll take the lump sum paid, multiplied by the fair value of the land divided by the fair value of the whole property. So this is basically will be a ratio. And the basis of the building, basically the same concept, whatever we paid lump sum amount paid times the fair value of the building divided by the fair value of the whole property acquired. It's a very simple process. Let's look at an example to see how it works. A taxpayer acquired the land with an attached building for $650. So now what happened is the whole price is $650. Now this $650, some of it will have to go to the land. Some of it will have to go to the building. The land had a fair value of $600,000. The building had a fair value of $150,000. So what do we have to do? Well, we add up the fair value, $600,000 plus $150,000. That's $750,000. That's the fair value of both assets, the total fair value of the deal. What we do now is we take $600,000 divided by $750,000. And this will be the percentage for the, that we multiply the $650,000. So if I took $600,000 divided by $750,000, simply put the land represent 80% of the deal. And obviously $150,000 divided by $750,000 must be 20% of the deal. Therefore of the $650,000, 80% going to go toward the land and 20% will go toward the building. And that's $650,000 times this ratio. This ratio is 80%. Then the same concept, $650 times this ratio, which is 20%. So $520 is the basis for the land, and $130 is the basis for the building. Now, would the basis stay the same forever? No, basis could go up, basis could go down. So we have adjustment to basis after we acquire the asset. So it doesn't remain the same. It increases and decreases as described in the following paragraph. It increases. When does it increase? The basis of an asset is mainly increased by the cost of capital improvement that have a useful life of more than one year in which increases the value of the asset, increases the length of the asset's life, ink, adapt the asset to a different use. So if we spend money, if we spend money on the asset, let's assume we have a truck. I'm really lousy at drawing, but let's assume that's the truck. Oh my God, this is bad. Let's assume that's the truck. Just forget it. Let's assume we purchase a truck. Now, what did we do? We paid for this truck $30,000. Now, what we did is we added a lift to that truck and that lift cost $3,000. A lift basically, now we can lift heavy items to put it on the truck. So rather than individuals cannot lift heavy items, but we added the lift. Well, this item increased the value of the asset. Okay, so now the basis of this truck, we add the $3,000 to the truck basis. Now the basis are $33,000. Another examples of basis will be putting a recreation room and an unfinished basement. Basically, you added, you increased the value of the asset, building a fence to a building, installing a new plumbing system that's going to increase the life of the property, paving the driveway that's also going to, it's considered capital improvement. We also, we could have decreases of basis. This usually happened when there are various factors that decrease the basis, such as cost recoveries. What does that mean? Cost recoveries is a fancy word for what we know is depreciation. So when we depreciate the asset, the basis go down. Okay, it's called cost recovery for tax purposes, casualty and theft losses. There was some damage, the asset, there was theft, then the basis are reduced and certain non-taxable distribution by corporation. We'll talk about this later on. Also, we have to understand the difference between capitalizing versus expensing. Again, this is a financial accounting as well as a tax concept. The cost of qualifying improvement or betterment with a useful life or more than one year should be capitalized. We talked about this on the prior slide. Okay, because these costs increase the asset basis and are often referred to as capital addition. This is the concept of capitalizing. So when we capitalize something, it means we treated as an asset. So we spend money on that lift to add it to the truck. We treat the lift as an asset, not an expense. In contrast, if we spend money on repair and maintenance costs, that should be expensed. These costs generally maintain the asset ordinary operating efficiency and do not affect its basis. So we expense. And this is the questions that we come up with every time we spend money. Do we capitalize this expenditure or do we expense the expenditure? Now, the funny thing about taxes is you always want to expense it. You want to find a way to expense the asset because as you expense the expenditure, it saves on your taxes. For financial accounting, you always want to capitalize it. You want to treat it as an asset because you don't want to take the expense now. Okay, now taxpayers are not required to capitalize the unit of property with an acquisition cost of 200 and less. If you pay 200 or less, guess what? Treat it as material and exp- treat it as material and supplies and go ahead and expense it and get done with it. Let's take a look at an example. During year one, Diana paid 75,000 to acquire real property consisting of land and building. Hopefully, we all know what real property is because we talked about this in a prior session. In connection with this acquisition, Diana paid commission of 1220 and legal fees of 470. The total cost of the property was allocated between the land and the building with the respective shares as 70 and 30, so just they gave us the proportion. Simply put, whatever we paid, it's going to be split 70% of the land, 30% of the building. Now, before de-placing the building in service, Diana incurred 12,500 in remodeling cost and toward the end of year one, Diana had a deductible casualty loss of 2,100. Moreover, Diana was allowed a deduction for depreciation of 3220 for year one. Now, the question is, what is the adjusted basis of the land as of January 1st, year two? So one year went by, now we're starting year two, what is the basis? Well, let's take a look at the basis. Well, first we paid 75,000 for the land, that's part of the basis. The commission is part of the basis, the legal fees part of the basis. All in all, we paid 76,690. Remember, this amount will have to be split between the land and the building. So let's do that first. The cost allocated between the land and the building is as follows, 76,690 times 70%. The land gets 53,683. The building gets 30% of the deal, $23,007. Those are the original basis. The building's basis is then adjusted as follows. Why? Well, we incurred 12,500 for remodeling cost, which is it's going to increase the value of the asset that's going to be added. So this is going to be added to the building, plus 12,500. We're going to decrease the basis of the building by the casualty loss, a casualty loss of 2,100. Then we also took a depreciation of 3,210. Well, as a result, we're going to take the $23,007, the original basis, plus 12,500 minus 2,100 minus 3,210. So the basis is $30,197 for the building. How about the basis for the land? Well, guess what? The basis of the land does not change. Land is not depreciable and we are not told anything about casualty loss or something like that. Usually the land is just whatever basis you have, it stays there until usually you sell it, which is equal to $53,683. We also have to be familiar with something called the Minimus Safe Harbor and this deals with what can we expense? The Minimus Safe Harbor is available for businesses that have a policy of immediately expensing low-cost personal properties for financial accounting purposes. Simply put, personal properties remember furniture's computers that are different than real property, fixed furniture I said, desks, so on and so forth. Business may elect to treat up to 2,500 per invoice of certain expenditure as an expense for income tax purposes. Remember it's 2,500 per invoice. Now, if you have your financial statement audited, you can go up to 5,000. Now, again, for tax purposes, you want to take this deduction for tax purposes, you will try to tell your vendor, bill me less than 2,500 per invoice, assuming it's not the same. You cannot take one asset and break it into several invoices, but assuming each invoice is separate for a separate asset. For example, you cannot take, for example, something that's going to cost you 6,500. That's a one asset. Let's assume an HVAC system. You cannot tell them, well, I purchased the motor for 4,000 or let's assume what you do is, okay, I purchased the motor for 2,200. The pipes cost 2,300 and something else costs the remainder. And look, I have three invoices, you can't do that because the HVAC is one unit. Now, if you're replacing your windows at the house, you have four different windows, you can invoice each window separately. Let's assume windows in an apartment building. You could invoice, you said each window is 2,000. It's a separate invoice because each window is independent from the other window. So just make sure you understand this concept. It's per invoice. If the cost of one item exceeds the allowable expendable amount, the entire cost should be capitalized. So the invoice is $8,000. You cannot take 2,500 and capitalize the rest. Once it's above the amount that's assuming 2,000 or 5,000, then you have to capitalize it. Let's take a look at a quick example. For financial statement purposes, Fahad has a policy of immediately expensing the cost of personal properties with the unit cost up to 7,500. During 20x1, Fahad acquired nine laptops for 2,200 each. Machinery with a cost of 7,000 and equipment for 4,900. Determine the amount that Fahad company should expense or capitalize for 20x1 for income tax purposes. Noting that the company has audited financial statement. Audited financial statement, this is going to put us at the 5,000. Now the laptops each one is 2,200. Each laptop is independent from the other laptop. So guess what? I can expense all the laptops. Machinery with a cost of 7,000, I can't take it because it's above exceeds the allowable amount. So I cannot take the 7,000 and equipment of 4,900. I can take that as well. Why? Because my financial statements are audited, I'm allowed up to 9,000. So for income tax purposes, Fahad should expense the entire cost of laptop as well as the cost of the items that's less than 5,000. On the other hand, the entire cost should be capitalized because it exceeds 5,000 for the machinery. It's important to highlight that whenever the cost of the tangible asset exceeds 5,000, the entire cost is capitalized. Be careful. They'll try to trick you to make you think that okay, you get 7,000, you can expense 5,000 and the 2,000 is capitalized. No, once it exceeds that amount, you capitalize it. So taxpayers are not allowed to expense the first 5,000 and capitalize the remaining. They will try to trick you. What should you do now? Whether you are a CPA candidate, EA candidate or an accounting student, take an A, an income tax course, go to Fahad lectures, subscribe, work MCQs, look at additional resources that's going to help you understand this concept better. Basis is important. It's only going to get more complicated from here. Learn the basics. I'm here to help. Your accounting education is worth it. Invest in yourself. Invest in your career. Good luck and stay safe.