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How Does the IRS Verify Cost Basis?

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From yahoo News:

A financial advisor explaining to clients how cost basis is verified.

The IRS expects taxpayers to keep the original documentation for capital assets, such as real estate and investments. It uses these documents, along with third-party records, bank statements and published market data, to verify the cost basis of assets. This is an issue that will come up if the IRS has reason to believe that your self-reported information is incomplete or wrong. In some extreme cases, if neither you nor the IRS can determine a satisfactory cost basis for your assets, the agency may require you to treat the cost basis as zero. Here’s what you need to know.

A financial advisor can help optimize your financial plan to mitigate your tax liability.

What Is Cost Basis?

Cost basis is the amount that you pay to buy an asset. In some cases it can be adjusted upward if you also spend money increasing that asset’s value.

The IRS uses cost basis to calculate your taxable capital gains. In general, when you sell an investment, real estate or some other asset, your capital gains are calculated as the sale price less the cost basis. This lets you pay taxes only on your profits from a sale, not the money you originally put in.

For example, say that you buy a share of stock for $15 and later sell it for $25. Your cost basis for this stock would be $15, the original amount you bought it for. Your taxable capital gains on this sale would be $10, the difference between what you sold it for and what you spent.

When you receive an asset without buying it, such as through a gift or inheritance, the IRS applies different rules to determine your cost basis. Each situation will work slightly differently based on the nature of the underlying transaction. When you inherit an asset, the cost basis is usually set to the fair market value of the property at the time of the decedent’s death. If the asset has gained value since the original owner bought it, the cost basis will be increased or “stepped up.”

Verifying and Determining Cost Basis

A man researching how the IRS verifies cost basis.

America uses a self-reporting tax code. This means that taxpayers are required to file their own taxes on which they declare the cost basis of their assets and any taxable capital transactions.

As part of this system, the IRS requires taxpayers to maintain the financial records necessary for any underlying assets. For capital assets, like stocks or real estate, you are required to maintain the records necessary to show their original cost basis.

If the IRS has reason to believe that your taxes are inaccurate or incomplete, it may conduct an audit. As part of this process it will look for documents to verify the cost basis of any assets that you have claimed on your taxes.

Among other documents, the IRS will look for:

Purchase Records

If you purchased the asset, documents from the original sale are the preferred option for verifying cost basis. This can include any brokerage statements, commission statements or other proof of purchase for securities that you purchased. It can include receipts or other proof of purchase for personal property, and it can include contracts for sale or closing statement for real estate.

While the details vary, the best verification of cost basis is the original documentation of the asset’s purchase.

Original Deeds or Records

If you don’t have the original document of sale, either you or the IRS will look for external records to verify the cost basis of an asset. For real estate, you can use external documents that list the sale price of the property. Depending on the jurisdiction, this can include deeds, offer letters, canceled checks or other records involved with the sale.

Third Party Records

If you don’t have necessary records, the IRS will look to third parties for confirmation of the asset’s cost basis. This can include pulling documents from banks, lenders and sellers to confirm the value of a real estate transaction or a personal property sale. It might include brokerage records to confirm the sale price of securities, or pulling bank statements to confirm your cash outflow on any given purchase.

The value of third party records will vary. In some cases, the IRS will accept these as effectively primary documents. For example, lenders and brokers are generally considered trusted third parties in their respective fields.

Market Prices and Comps

When you inherit assets, the step-up rule makes it more difficult to establish an asset’s new cost basis. The cost basis of your inherited assets is typically set to the fair market value at the time of the original owner’s death. (In some cases, estate management may set the cost basis to a later date, typically within six months of the decedent’s death.)

It is the job of the executor or administrator to establish cost basis of any inherited assets, and to provide adequate documentation to that effect. As a starting point, the value of an asset for estate tax purposes can be used for the asset’s cost basis as well. That is to say, if a bundle of stocks is valued at $10,000 for the purposes of determining estate tax eligibility, then their cost basis is also considered to be $10,000 for the purpose of inheritance.

The documents you will need to verify fair market value at time of death will depend on the asset. For assets with a public market, like exchange-traded stocks, you may need nothing more than the published prices for the date in question. For taxable property, you can rely on the assessed tax value. For example, most towns assess a property tax value on assets like cars and real estate, which you can use as proof of their value.

Finally, you can use what are known as “comps.” This is particularly useful for more illiquid assets like real estate. Comps are the published sale price for comparable assets. For example, if you inherit a three bedroom house you can look up what other three bedroom houses in the area have recently sold for. This can establish the market for your asset and help you establish its value.

Bottom Line

A financial advisor helping a client verify the cost basis of a capital asset.

To verify the cost basis of a capital asset, you will typically need either original documents, third party evidence or published market data. The details will depend on the specific assets involved, and can get particularly complicated when you’re stepping up inherited assets. Therefore, it may be in your interest to work with a financial advisor to make sure that you have complete and accurate information, especially for securities.

Tips on Managing Capital Gains Taxes

A financial advisor can help optimize your investment portfolio to lower your capital gains taxes. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

SmartAsset’s capital gains calculator can help you estimate how the gains you earn when selling stocks will be impacted by capital gains taxes in your location.

Photo credit: ©iStock.com/kate_sept2004, ©iStock.com/Inside Creative House, ©iStock.com/prpicturesproduction

The post How Does the IRS Verify Cost Basis? appeared first on SmartReads by SmartAsset.

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