Section 61(a)(3) informs us that a taxpayer’s “gross income” includes gains derived from dealings in property. Intuitively, we know that a gain derived from a dealing in property is the price at which a seller sells property minus the price that the seller paid for the property. In the context of an income tax, why should we subtract anything to determine what income arises from gains derived from dealing in property? “It’s obvious” is not an answer. After all, in the case of a property tax, the tax authorities would not care what price the owner of property paid except as evidence of its current fair market value.
Section 61(a)(3) informs us that a taxpayer’s “gross income” includes gains derived from dealings in property. Intuitively, we know that a gain derived from a dealing in property is the price at which a seller sells property minus the price that the seller paid for the property. In the context of an income tax, why should we subtract anything to determine what income arises from gains derived from dealing in property? “It’s obvious” is not an answer. After all, in the case of a property tax, the tax authorities would not care what price the owner of property paid except as evidence of its current fair market value.
Section 1001(a) instructs us how to determine the measure of gains derived from dealing in property. Subtract “adjusted basis” from the “amount realized,” i.e., the amount of money and the fair market value of any property received in the transaction. Hence, a taxpayer’s adjusted basis in an item is not subject to income tax. The reason for this is that a taxpayer’s adjusted basis represents savings that remain from income that has already been taxed. The purchase of something from a taxpayer’s “store of property rights,” to the extent that it is not for consumption, represents only a change in the form in which taxpayer holds his/her wealth. It does not represent an additional increment to wealth and so does not fall within the SHS definition of “income.” It should never again be subject to income tax lest we violate the first of our guiding principles by taxing the income necessary to purchase the item twice.
Investment, Basis, Depreciation, and Adjustments to Basis
An investment in an income-producing asset represents merely a change in the form in which a taxpayer holds after-tax wealth. A change in the form in which taxpayer holds wealth is not a taxable event. We assure ourselves that the change is not taxed by assigning basis to the asset. When the investment is in an asset that will eventually but not immediately be used up in the production of other income, income-producing consumption and “de-investment” occur simultaneously. The income-producing consumption is deductible – as is all (or almost all) income-generating consumption (§ 162) – and so reduces taxable income. This expense of generating income is separately accounted for in whatever name as depreciation, amortization, or cost recovery. The accompanying de-investment requires a reduction in the adjusted basis of the income-producing asset.
Section 1012(a) tells us that a taxpayer’s “basis” in something is its cost. Taxpayer will pay for the item with money that was already subject to tax upon its addition to his/her store of property rights. Section 1011(a) tells us that “adjusted basis” is basis after adjustment. Section 1016 tells us to adjust basis upwards or downwards according to whether taxpayer converts more assets from his/her store of property rights in connection with the property (§ 1016(a)(1)) or consumes a portion (§ 1016(a)(2)) of the property, i.e., improves it, or consumes some of it in connection with his/her trade or business, or in connection with his/her activity engaged in for profit (i.e., depreciation (cost recovery) or amortization). The upshot of all this is that adjusted basis represents the current score in the game between taxpayer and the Government of what wealth has already been subject to tax and so should not be subject to tax again.
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