[MUSIC] Welcome back, recall from the previous video, our formula for determining gains and losses. In the previous video, we focused on the Amount Realized which, at a high level, is all the stuff that the seller got a value as a result of a property transaction. This can include getting cash or other property or getting rid of a liability. But to obtain the realized gain or loss, we need to compare the amount realized to the adjusted basis of the property. In this video, I'll introduce the concept of adjusted basis and we'll do an example. Adjusted basis is defined as the original basis of the property reduced by accumulated cost recovery deductions, and or increased by any capital improvements. Recall from the previous set of videos where we discussed cost recovery deductions. If we sum each year's depreciation deductions, we will obtain the accumulated depreciation on that asset over time. This accumulated depreciation will reduce the original basis of the asset. That is, it will adjust the basis downwards. The same idea holds if it's in an intangible asset, the accumulated amortization will decrease the original basis of the intangible. Or, if it's a natural resource the accumulated depletion will reduce the original basis in the natural resource. If however, there are any capital improvements that extend the life of the particular asset, then we will increase the basis by that amount, that is we will adjust the basis upwards. In short, the formula for Adjusted Basis = the Original Basis- the accumulated Cost Recovery Deductions + any Capital Additions. Here's a very short example that builds on the previous videos on cost recovery. Let's say a business owner purchased a computer two years ago from $1,200, recall the computers are 5 year property. And let's assume that computer is being depreciated using the half year convention. Meaning the first and last year of the assets life, will receive half a year's worth of depreciation. So, in Year 1, the depreciation will be $240 or the $1,200 basis times the 20% depreciation rate in the half year convention table for 5-year property in recovery Year 1. The Year 2 depreciation will be $384 or $1,200 of the original basis times the 32% rate in the half year convention table for 5-year property in recovery Year 2. So what's the adjusted basis at the end of Year 2 of the computer? Well, it's the original basis of $1200 minus the Year 1 depreciation of $240 minus the Year 2 depreciation of $384. Therefore the adjusted basis is $576. This is the conceptual equivalent of the net book value of the asset on the balance sheet. The original basis here is netted or adjusted to reflect the accumulated depreciation on the asset over the time it's been used by the tax payer. Knowing the Amount Realized from the previous video and now the Adjusted Basis from the last slide we can calculate the Realized gain or loss. This is defined quite obviously as the gain or loss that is realized on sale, disposition, or exchange of the asset. That is, it reflects the economics of the transaction. Did the taxpayer gain or lose on the transaction? The formula here helps to see this comparison. Here the gain or loss realize is simply the difference between the amount realized and the adjusted basis. Again we can think of the amount realized as what the tax payer got, a value, in the transaction. Whereas the adjusted basis is the basis or the net book value of what the taxpayer gave up in the transaction. So let's build on the example in the previous slide. If I decided to sell the computer from the previous example for $600, do I have a gain or a loss? Recall that I bought the computer for $1200 2 years ago, does this mean I have a loss, since I sold the $1200 computer for just $600? Well, not exactly, because the $1,200 dollars doesn't reflect the fact that I used the computer over the last 2 years. What I have to do is compare the $600 amount realized to the adjusted basis of $576, which reflects the accumulated depreciation on the computer up to the time of sale. Therefore, I actually have a Realized Gain of $24. I got more in economic value than the tax basis of what I gave up by $24. Here are few more examples. Let's say we have three business use assets, office furniture, a warehouse, and a delivery truck. We sell the furniture for $12,000, the warehouse for $350,000 and the truck for $2,000. We need to compare the amount realized in column a to the adjusted basis in column d in order to figure out a realized gain or loss in the last column. Now, to figure out the adjusted basis, we need the original cost, which is reported in column b. And we need to subtract out the accumulated depreciation reported in column c. Taking the difference in these two columns gives us the adjusted basis in column d. For example, the furniture costs $10,000, and it's been depreciated by $7,000. Therefore the adjusted basis is $3,000. The warehouse cost $275,000 and was depreciated by $15,000. So the adjusted basis is $260,000. Finally, the delivery truck costs $15,000. It has accumulated depreciation of $10,500, which leaves us with an adjusted basis of $4,500. So to get to the realized gain or loss, we take the amount realized in column a, upon the sale of each asset, then subtract the adjusted basis in column d. So the furniture here has a gain of $9,000 or the $12,000 amount realized minus the $3,000 adjusted basis. The warehouse has a $90,000 gain or the $350,000 amount realized minus the $260,000 adjusted basis. And here the truck has a realized loss or the $2,000 amount realized minus the $4,500 adjusted basis. In total we have a realized gain of $96,500. So in summary, in order to obtain the realized gain or loss, we must take the difference between the amount realized, and the adjusted basis. We looked at the amount realized in the previous video. But in this video we saw that the adjusted basis is the original cost, minus accumulated cost recovery, plus any capital improvements. At a high level, the realized gain or loss is like the economic gain or loss from the transaction. We compare all the stuff that the taxpayer got of value, ie, the amount realized, to the net book value or adjusted the tax basis of what the tax payer gave up.