Basis Overstatement is Income Omission for 6-Year Limitations Period

For a brief period, the IRS was limited by the U.S. Supreme Court to 3 years when challenging a taxpayer’s cost basis. Cost basis for example is used to determine the gain on the sale of property (Sale proceeds less cost basis equals gain). In general, a valid assessment of income tax liability may not be made more than 3 years after the later of the date the tax return was filed or the due date of the tax return. However, a 6-year period of limitations applies when a taxpayer “omits from gross income” an amount that's greater than 25% of the amount of gross income stated in the return.

In the case of a trade or business, the term “gross income” means the total of the amounts received or accrued from the sale of goods or services (if such amounts are required to be shown on the return) prior to the diminution by the cost of such sales or services. In determining the amount omitted from gross income, there isn't taken into account an amount omitted from gross income stated in the return if the taxpayer adequately discloses the fact of the omission on the return or in an attached statement.

Congress, however, jumped in and in the “Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, specifically changed the law to state that an  understatement of gross income by reason of an overstatement of unrecovered cost or other basis is an omission from gross income for purposes of the six-year limitations period. (Code Sec. 6501(e)(1)(B)(ii), as amended by Act Sec. 2005(a)(1))

The Act also excludes the mere disclosure of the cost or other basis as meeting the adequate disclosure rule. (Code Sec. 6501(e)(1)(B)(iii), as amended by Act Sec. 2005(a)(2)).

Determining the proper cost basis can be complex and requires good records to support the cost basis being used. Common mistakes by taxpayers in determining their cost basis include:

1.    Not reducing the basis for depreciation taken,

2.    Adding repair amounts that were previously expensed,

3.    Forgetting improvements,

4.    Not taking advantage of opportunities to “step-up the basis.”

For more information contact Gosule, Butkus & Jesson, LLP.