38.2 Property Basis and Character Workpaper
Key Takeaways
- Basis is the starting point for depreciation, realized gain or loss, recognized gain or loss, and character classification.
- Purchased property starts with cost, including capitalized acquisition costs needed to place the property in service.
- Property converted from personal to business use uses the lower of adjusted basis or fair market value at conversion as the depreciation and loss anchor.
- Character is a separate decision from amount: the same numeric gain can be capital, ordinary, Section 1231, or Section 1245/1250 recapture depending on the asset and facts.
- A property workpaper shows amount realized, adjusted basis, realized gain or loss, recognized amount, character, and return destination (Schedule D vs. Form 4797).
Basis Before Character
REG property questions follow a fixed sequence. First establish basis, then adjust it, then compare it with amount realized, then determine character and return destination. If you jump to Schedule D or Form 4797 before measuring basis, you may classify the right asset with the wrong amount.
The core formula: realized gain or loss equals amount realized minus adjusted basis. Amount realized includes cash, the fair market value (FMV) of property received, and liabilities the buyer assumes. Adjusted basis begins with proper original basis and then changes for capital improvements (added), depreciation allowed or allowable (subtracted), amortization, casualty losses, and reimbursements.
Basis Source Table
| Fact pattern | Original basis anchor | Common adjustment |
|---|---|---|
| Purchased business equipment | Cost plus capitalized acquisition costs | Depreciation allowed or allowable reduces basis |
| Personal asset converted to business use | Lower of adjusted basis or FMV at conversion | Post-conversion depreciation reduces basis |
| Gifted property | Donor basis for gain; FMV for loss (dual basis) | No gain/loss zone between the two anchors |
| Inherited property | FMV at date of death (or 6-month alternate valuation if elected) | Always treated as long-term holding |
| Wash-sale replacement stock | Replacement cost plus disallowed loss | Holding period tacks from old shares |
Workpaper Columns
Use the same columns every time: (1) Asset and use (investment, personal-use, inventory, depreciable business property, real property, intangible); (2) Basis source; (3) Adjustments (add capital expenditures, subtract recovery); (4) Amount realized; (5) Recognized amount (consider deferral or disallowance only after realized gain is known); (6) Character and destination (capital assets generally go to Schedule D; Section 1231/1245/1250 business property goes to Form 4797).
Drill 1: Purchased Equipment
A sole proprietor buys packaging equipment for 60,000, pays 2,400 freight and installation, and later claims 18,000 of depreciation. The asset sells for 51,000 cash.
| Step | Amount | Explanation |
|---|---|---|
| Purchase price | 60,000 | Cost basis starts here |
| Capitalized freight/installation | 2,400 | Necessary to place asset in service |
| Original basis | 62,400 | Cost plus capitalized costs |
| Less depreciation | (18,000) | Allowed or allowable recovery |
| Adjusted basis | 44,400 | Basis before sale |
| Amount realized | 51,000 | Cash proceeds |
| Realized gain | 6,600 | Proceeds exceed adjusted basis |
Character is not automatically capital. This is Section 1245 property, so gain is recaptured as ordinary income up to the 18,000 of depreciation taken. The 6,600 gain is fully ordinary recapture and reports on Form 4797, Part III, never Schedule D.
Drill 2: Personal Asset Converted to Business Use
A camera bought for 8,000 personal use is converted when its FMV is 5,000. After conversion, 1,200 of depreciation is allowed; it sells for 3,300. For loss analysis, start with the lower conversion FMV of 5,000, subtract 1,200, giving a loss basis of 3,800. The 3,300 sale yields a 500 loss before limitations. The exam trap is using the 8,000 personal cost to inflate the loss; converted-asset loss basis can never exceed FMV at conversion.
Drill 3: Gifted Stock Dual-Basis Check
Donor basis is 20,000; FMV on the gift date is 14,000. Sell for 23,000, use donor basis, recognize 3,000 gain. Sell for 12,000, use FMV for loss, recognize 2,000 loss. Sell for 17,000 (between the anchors), recognize no gain or loss. Contrast inherited property: basis steps to FMV at death and is automatically long-term regardless of how long the heir holds it.
Character Checklist
| Asset | Return destination | Character warning |
|---|---|---|
| Investment stock | Form 8949 and Schedule D | Watch holding period and wash sales |
| Inventory | Schedule C ordinary income | Never a capital asset |
| Depreciable equipment | Form 4797 | Section 1245 recapture is ordinary |
| Rental/commercial building | Form 4797 | Section 1250 and unrecaptured gain rules |
| Personal-use asset sold at a loss | No deduction | Personal losses are disallowed |
Drill 4: Section 1231 Netting
Section 1231 assets are depreciable property and real property used in a trade or business held more than one year. The benefit is asymmetric: a net Section 1231 gain is treated as long-term capital gain (preferential rates), while a net Section 1231 loss is treated as ordinary (fully deductible against other income). Before that netting, depreciation recapture is carved out: Section 1245 recaptures all prior depreciation on personal property as ordinary income, and Section 1250 recaptures only depreciation above straight-line (rare today since modern realty uses straight-line).
A separate five-year lookback rule recharacterizes current-year net 1231 gain as ordinary to the extent of unrecaptured net 1231 losses claimed in the prior five years. Candidates routinely forget the lookback and overstate capital gain.
Recognition Exceptions to Memorize
Realized gain is not always recognized. Common deferral and exclusion rules tested on REG include the like-kind exchange under Section 1031 (real property only since 2018, deferring gain to the extent no boot is received), the involuntary-conversion deferral under Section 1033, the Section 121 home-sale exclusion (250,000 single / 500,000 married filing jointly if the ownership and use tests are met for two of the last five years), and the related-party loss disallowance under Section 267. Always compute realized gain first, then apply the exception, then state the deferred basis that carries into the replacement asset.
Review Point
A complete property answer says more than gain is 6,600. It states which basis rule applied, what adjustments were made, whether the amount is realized and recognized, what character governs (capital, Section 1231, or Section 1245/1250 ordinary recapture), and where the item lands on Schedule D or Form 4797. That distinguishes a calculator answer from a CPA workpaper.
A taxpayer buys business equipment for 40,000, pays 1,500 to install it, claims 9,000 of depreciation, and sells it for 35,000. What is the adjusted basis immediately before sale?
A donor gives stock with a basis of 20,000 when its fair market value is 14,000. The donee later sells for 17,000. What gain or loss is recognized?