Recall from our previous videos, that we've been looking at calculating realized gains or losses as the difference between the amount realized and the adjusted basis. Here from the seller's perspective, the amount realized is the sum of any cash received plus fair market value of other property received plus the disposition of liabilities minus selling expenses. The adjusted basis was defined as the original cost-basis minus accumulated cost recovery deductions like accumulated depreciation plus capital additions. In the simplest terms, the realized gain is the difference between the value of what the taxpayer got and the adjusted basis of what the taxpayer gave up. In this video, we'll look more closely at what makes up the calculation in the adjusted basis. In particular, we'll look more closely at the original basis of the property. Importantly, how does this basis get here? While the original basis depends on how the property was originally acquired. The first major and probably most common way to acquire property is to simply purchase or buy the property. So if that property is acquired through a purchase, the taxpayer will simply use the cost basis of the property. For example, if I'm selling land to someone and I originally bought the land for $100,000, then the basis I'll use to calculate whether or not I have a gain or loss will be that $100,000. That is the cost of land to me upon my original acquisition of the land. There are a couple of extensions here I'd like to discuss. If the property was purchased through what is known as a bargain purchase, then the basis equals the fair market value of the property at the time of the purchase and not what the purchaser originally paid for the property. This difference between the cost paid for the property and its fair market value actually gets included in the basis. That is the basis is adjusted upward from the price paid up to the fair market value, and this upward adjustment will actually be included in the buyer's gross income and gets taxed. The reason this happens is because once a taxpayer pays tax on its income, it establishes basis and in the future when the property is sold, the taxpayer will use the higher adjusted basis that reflects the fair market value and not the lower adjusted basis that reflects the price paid for the property. An example here might be useful. Let's say an employee purchased land from her employer through a bargain purchase agreement for $20,000, but the fair market of the land was $30,000 at the time of the purchase. What happens here is the employee recognizes that $10,000 difference between the price paid and the fair market value in income essentially as compensation and pays tax on it. This recognition of income allows the land spaces to be adjusted upwards to $30,000. So if in the future let's say the land is sold by the employee for $100,000, the gain will be $70,000, or $100,000 minus the $30,000 adjusted basis, and not the $100,000 minus the $20,000 price paid. Now, if multiple assets were acquired in a lump sum purchase that as one purchase price for more than one asset, the taxpayer has to allocate the total cost of the purchase to the individual assets based on the individual asset's fair market value. Here the purchase price is assigned to the assets excluding goodwill to the extent of their fair market value. Goodwill represents any excess amount paid for the assets above the total fair market value of those assets. If the taxpayer pays more than the total fair market value of the assets, then goodwill becomes its own asset. In fact, it's an intangible asset and as amortized as such. We do not allocate or spread the value of goodwill across the other individual assets that we purchased. That is goodwill does not increase each assets' basis based on how much the taxpayer overpaid for each asset. Let's look at an example of how a lump sum purchase works. Here we have Sheila, who runs a business that rents apartments to tenants. She sells three of her buildings to Natalie in unrelated party for a total of one million dollars. Natalie is a savvy buyer and negotiated a very favorable deal. The appraisal show the following fair market values. Building one is worth $400,000, building two is worth $800,000 and building three is worth $200,000 for a total fair market value of $1,400,000. What is Natalie's basis in each building she purchased from Sheila? Again, Natalie only paid one million dollars for these three buildings. Well, first let's set up a table here where we look at each building separately. Here we confirm that the total fair market value is 1.4 million. Now, what we need to figure out is how much of the $1.4 million does each building represent in terms of relative fair market value. To do that, we divide the individual fair market value of each building by the $1.4 million total fair market value. So for building one, we divide $400,000 by $1.4 million. For building 2, we divide $800,000 by 1.4 million, and for building three, we divide $200,000 by 1.4 million. What we get are the percentages based on the relative fair market values of each building. So building one represents 28.6 percent of the total fair market value in this lump-sum purchase. Building two represents 57.1 percent of the total fair market value and building three represents 14.3 percent of the total fair market value in this lump-sum purchase. So we take these percentages and allocate them to the total purchase price in this lump sum purchase. In particular, the sales price was one million dollars. So we take the percent of total fair market value for each building and multiply it by one million dollars to obtain the basis in each building. So for building one, we multiply 28.6 percent by the one million dollars to get a basis of $286,000. For building two, we multiply 57.1 percent by the one million dollars to get a basis of $571,000. For building three, we multiply 14.3 percent by the one million dollars to get a basis of $143,000. You add them up and you should get the total basis of one million dollars, which equals the price paid. So here because Natalie paid less for the buildings than their total fair market value, she needs to allocate that purchase price across each building based on each building's relative fair market value to the total fair market value. Now, let's change one fact, and let's say that Natalie bought the three buildings for $1.5 million, not one million dollars. The three buildings represented Sheila's entire business. What happens here? How would you treat the goodwill? So what happens here is that Natalie paid $1.5 million for buildings with a total fair market value of $1.4 million. In effect, Natalie overpaid for the buildings. Maybe she did that because she thinks that buildings will be even more valuable in the future. So how did she figure out her basis in each building. Does she allocate the price based on the relative fair market value percentages. Well, in this case because the purchase price was greater than the total fair market value of the assets, she will not need to allocate the purchase price to each asset the way we did in the previous example where Natalie paid less than the total fair market value. Here Natalie will simply use the fair market value of each building as her new basis in each building and any excess amount she paid, that is the goodwill, will become its own asset. It's actually quite straightforward in this case, this is how it looks. This is the fair market value of each building as we known from the fact pattern. Again the total fair market value totals to $1.4 million. Because the purchase price of $1.5 million was more than the total fair market value of $1.4 million, the fair market value of each building simply becomes the basis in each building. Therefore, the basis in building one is simply $400,000. The basis in building two is $800,000, and the basis in building three is $200,000. What happens to that excess $100,000 that was paid, or the difference between the $1.5 million paid and the $1.4 million total fair market value. Here the $100,000 becomes its own asset called goodwill. It is an intangible asset that is amortized over 180 months straight line as we saw in a previous video. We do not allocate that $100,000 according to the relative fair market values of each building. We can't do that because buildings are depreciated as tangible realtys in the mid-month convention and goodwill is an intangible asset. So if we were to basically spread the basis of the goodwill across the three buildings, we'll be mixing apples and oranges. That is mixing up the different types of assets. We can't do that here. Here to the extent there is goodwill, it becomes its own asset. In summary, we're starting to look more closely at adjusted basis. In this video, we look more closely at the cost basis or the basis that is established when a taxpayer purchases property. We looked at a bargain purchase situation and a lump-sum purchase situation. In the lump sum purchase situation, if the price paid is less than the total fair market value of the asset purchased, then the taxpayer has to allocate the purchase price across the assets based on their relative fair market values. However, if in a lump sum purchase, the purchase price is greater than the total fair market value of the assets purchased, then the taxpayer's basis in the new assets simply equals the fair market value in each asset with the remaining excess amount paid or the goodwill becoming its own asset.