11.1 Cost Basis and Conversion from Personal Use

11.1 Cost Basis and Conversion from Personal Use

REG Area III, Group A asks you to calculate the tax basis of an asset purchased for use in a trade or business and calculate the tax basis of an asset converted from personal to business use. Those two tasks sit at the front of property taxation because every later MACRS, §179, gain, or loss figure starts here. Cost recovery is the next chapter. This section stops at initial basis of tangible property.

Cost basis — IRC §1012

The unadjusted basis of purchased property is its cost. Cost is not merely the check written to the seller. It is the sum of:

• Cash paid to the seller
• Liabilities the buyer assumes, or to which the property is taken subject, in the purchase (including a nonrecourse mortgage that remains on the land)
• The fair market value of other property or services the buyer transfers as part of the price
• Capitalized acquisition costs that are not currently deductible

Leaving debt out of basis understates later depreciation and understates amount realized when that debt is later relieved. REG tests the arithmetic: if the buyer pays $40,000 cash, takes a machine subject to a $55,000 seller-financed note, and pays $2,500 of sales tax, freight, and installation to place it in service, initial basis is $97,500. An $800 incidental repair in week two that neither improves the machine nor adapts it to a new use is a current IRC §162 expense, not basis.

Capitalized costs versus currently deductible repairs

IRC §263(a) denies a current deduction for amounts paid for new buildings, permanent improvements, or betterments that increase the value of property. Post-acquisition spending on a unit of property is sorted as follows:

• Capital improvements — a betterment, a restoration, or an adaptation of the unit to a new or different use. Replacing a roof, adding a loading dock, or rebuilding an engine after its cost has already been taken into account is typical capital spending. Add it to basis and recover it under Area III.B, starting at /study-guides/cpa-reg/cost-recovery/macrs.
• Currently deductible repairs — incidental amounts that keep the unit in ordinary operating condition without materially adding value, prolonging useful life, or adapting it to a new use. A tune-up, a broken-window replacement, or a routine service call is the usual pattern.

Acquisition-cost items that REG expects you to capitalize into the purchased asset — or to allocate between land and building — include sales tax on the purchase, freight-in, installation and assembly, buyer’s commissions, title insurance, recording and transfer fees, and legal fees to acquire the asset. They are not repairs merely because they appear on a vendor invoice in the first month.

Land is not depreciable. A single closing statement for realty must be allocated between land and improvements on a reasonable FMV basis. Only the improvement slice is MACRS property.

Worked allocation. Purchase price $300,000. Independent appraisal: land $90,000 (30 percent), building $210,000 (70 percent). Capitalized closing costs $6,000 are allocated on the same 30/70 split. Land basis is $91,800. Building basis is $214,200. Putting the entire $306,000 into a 39-year building account is a basis error, not a convention error.

Uniform capitalization at REG depth — IRC §263A

UNICAP is not a cost-accounting exam. The REG idea is one sentence long: a taxpayer who produces real or tangible personal property, or who is a reseller still subject to the rule, must capitalize direct costs and allocable indirect costs into inventory or into the basis of the produced asset. Direct materials, direct labor, and factory overhead that benefit production are not a current deduction. They attach to basis and come out later as cost of goods sold or as extra depreciable basis of a self-constructed building or machine.

A small-business exception keyed to the inflation-adjusted average annual gross receipts test of IRC §448(c) takes many taxpayers out of UNICAP. The dollar threshold is indexed. The AICPA’s REG assumption is that you will not be tested on specific inflation-indexed amounts, so do not memorize this year’s receipts figure. Know that the exception exists, that it is a receipts test, and that a taxpayer who remains in UNICAP capitalizes production overhead rather than deducting it. Interest is separately capitalized on certain produced real property and other long-lived property under §263A(f). Mixed service costs can be inventoriable for resellers who do not qualify for the exception. If the stem is a cash-method shopkeeper clearly inside the receipts exception, do not invent a UNICAP pickup.

Worked UNICAP (exception does not apply). Direct materials $10,000, production wages $4,000, allocable factory overhead $2,000, and $400 of office paper used in general administration. Inventoriable cost is $16,000. The $400 is not a production cost.

Do not confuse UNICAP with the repair-versus-improvement rules. UNICAP asks whether production or resale overhead is inventoriable. Section 263(a) asks whether an expenditure on an already-owned unit of property is a capital improvement.

Conversion from personal to business use

A taxpayer who starts using a personal car, a former residence, or a personal computer in a trade or business — or for the production of income — has not bought a new asset. There is no fresh §1012 cost. The Code will not let that taxpayer convert a personal decline in value into business depreciation or a business loss.

Depreciable basis and loss basis equal the lesser of fair market value or adjusted basis on the conversion date.

Gain basis remains the taxpayer’s adjusted basis, later reduced by post-conversion depreciation.

That split is the same dual-basis idea §1015 uses for gifts, and it exists for the same reason: personal losses are not deductible.

Worked conversion. A taxpayer converts a car to business use. Adjusted basis is $28,000. FMV on the conversion date is $18,000. Depreciable basis is $18,000, not $28,000. MACRS in the next chapter runs from $18,000. The $10,000 of pre-conversion personal decline is gone for depreciation and for loss.

After conversion, suppose the taxpayer has taken $2,000 of MACRS. Remaining loss basis is $16,000 ($18,000 − $2,000). Remaining gain basis is $26,000 ($28,000 − $2,000).

Selling inside the band does not unlock the $10,000 personal drop. That is the point of the lesser-of rule.

Holding period. Conversion is not an acquisition. The holding period of the converted asset includes the time the taxpayer already held it for personal use. What starts at conversion is the MACRS recovery period and convention, not a new holding period.

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