The Story of Basis

By Jeanne Sullivan, J.D., LL.M.



  • Basis in an asset can result from a taxpayer’s investment of loaned funds, regardless of whether the loans are recourse or nonrecourse to the taxpayer.
  • Subject to Secs. 465 and 469, S corporation shareholders can deduct losses passed through from an S corporation up to the amount of their basis in the corporation, including their debt basis in the corporation. However, debt basis is limited to indebtedness of the S corporation directly to the shareholder.
  • When a shareholder contributes money or encumbered property to an S corporation, the form of the transaction may determine whether the transaction creates debt basis in the S corporation for the taxpayer.

Basis is a beneficial concept for a taxpayer—it shields the taxpayer from tax on the sale of an asset and can produce losses that reduce tax liability. It has been described as a “summary of the tax impact of [past] events” that have affected an asset. 1 Nevertheless, basis can be elusive: It can appear or disappear when we are not paying attention. 2 It can cling to an asset, be adjusted up or down, replicate itself, or shift to another asset. In other words, the summary that basis provides can have a number of potential twists and turns.

This article explains some of the basics of basis and one of the subplots in the general story it tells, using the following situation:

Example 1: A has decided to invest in real estate, so she takes funds that she has recently inherited ($400x) and buys a 20% interest in land. The seller is looking for a buyer for the other 80% of his real estate.


A will have a cost basis in her 20% interest in the real estate. Although there is no all-purpose definition of basis for tax purposes, according to Sec. 1012 the basis of property is its cost, except as otherwise provided. There does not appear to be any issue associated with determining A’s basis in her 20% interest in the land after she buys it. If she were to sell the 20% interest in the land, she would be able to get back her $400x without tax consequences; her basis in the 20% interest reflects the amount she paid for the land.

The underlying principle of basis determinations is expressed by the general meaning of the word “basis”: “a relation that provides the foundation for something . . . the fundamental assumptions from which something is begun or developed or calculated or explained.” 3 Under the federal tax laws, that fundamental assumption or foundation is the measurement or amount that the owner of property is treated as having invested in the asset, the amount that the taxpayer can withdraw or receive from the property without realizing income or gain from the property. As a result, to the extent basis includes untaxed dollars, basis determinations can provide the foundation for a tax shelter, allowing taxpayers to receive what some may perceive to be excessive tax benefits. From another perspective, as long as basis accurately tracks what is defined as the taxpayer’s economic investment in property, it is performing its function appropriately.

Basis from Proceeds of Debt

Under a traditional balance sheet approach to wealth, if both the asset and liability sides of the balance sheet increase equally, there is no net increase in net worth. Thus, incurring debt does not increase a taxpayer’s net worth; the cash received as debt proceeds is exactly offset by a liability to repay the debt. Because under our income tax system a taxpayer must “realize” income or gain before tax is imposed, borrowing money does not have immediate tax consequences. Borrowed cash is full basis, untaxed money in the borrower’s hands. These funds may be used to purchase assets with a full cost basis that enable the taxpayer to earn profits and suffer losses in operating or disposing of the assets. 4 If the debt is genuine and reasonable in terms of the fair market value (FMV) of the purchased property, the full amount of borrowed funds generally gives rise to cost basis. 5

Example 2: A wants to get started building on her land, but the seller has not been able to find a buyer for the rest of the land parcel. A discusses this with her banker, who suggests that she could borrow enough money to buy the seller’s entire parcel. Because A is risk averse, the banker suggests that she borrow the funds on the security of the purchased real estate, without any personal obligation to repay the debt. A is intrigued by the possibility of obtaining money to make the investment and not being personally obligated to repay the loan.


The banker is suggesting that A borrow on a nonrecourse basis. Generally, nonrecourse debt is debt for which the lender has no recourse against the borrower personally, and the lender can proceed against the security for the loan only if the borrower defaults. Debt for which the borrower has personal liability is termed recourse debt.

Recourse and Nonrecourse Debt in Crane and Tufts

The tax treatment of recourse debt generally has been clear: The obligor has full basis in cash or property acquired with recourse debt and, if a buyer assumes, or takes the property subject to, a mortgage for which the seller is personally liable, the full amount of the recourse debt is included in the seller’s amount realized. Because the buyer is treated as satisfying a personal obligation of the seller, under the principles established in Old Colony Trust Co. and Hendler,6 the seller has income equal to the amount of the obligation satisfied. As a result, the tax treatment of recourse debt is not controversial: The borrower has full basis in assets acquired with recourse debt, and the amount realized on the sale of the asset subject to the debt includes the full amount of the debt. Because there is no personal liability for nonrecourse debt, however, the buyer who assumes (or takes subject to) nonrecourse debt is not satisfying an obligation of the seller. Thus, the proper tax treatment of nonrecourse debt both for basis purposes and to determine the amount realized on the sale was originally uncertain.

The Supreme Court established favorable tax treatment of nonrecourse debt in Crane. 7 In that case, Mrs. Crane inherited a mortgaged apartment building and lot from her husband. The property had an appraised value equal to the mortgage. Mrs. Crane operated the building, collected the rents, paid for operating expenses and taxes, and paid the net amount to the lender for seven years. She reported the gross rentals as income and claimed expenses for taxes, operating expenses, depreciation, and interest on the mortgage. On November 29, 1938, with foreclosure looming, Mrs. Crane sold the property to a third party for $3,000 in cash, subject to the mortgage, and paid $500 in sale expenses. For tax purposes, she claimed that the property’s FMV was zero at the time she inherited it and that she had a zero basis in the property. She reported the cash received, minus expenses, as gain on sale of the apartment building.

The IRS argued that the property’s value was not the net equity but the gross value of the property undiminished by the mortgage and that its original basis in Mrs. Crane’s hands was $262,042.50, its appraised value in 1932 ($55,000 allocable to land and $207,042.50 to building). During the seven years that Mrs. Crane held the building, there was allowable depreciation of $28,045.10 on the building, leaving an adjusted basis of $178,997 at the time of sale. Moreover, the IRS argued that the amount realized on sale included both the cash received and the amount of the mortgage that the buyer assumed.

The Supreme Court was divided when it decided Crane. The decision rested on a number of theories. The Court determined that the nature of debt as recourse or nonrecourse is not relevant to the calculation of the purchaser’s basis when property is purchased with the proceeds of a borrowing. Because the taxpayer is obligated to repay the loan, the taxpayer includes the full amount of the loan in basis. The Court proceeded to treat the amount realized in the same way it had treated basis, including the full amount of the debt as proceeds of the sale of the underlying property. As the Court explained:

[W]e are no more concerned with whether the mortgagor is, strictly speaking, a debtor on the mortgage, than we are with whether the benefit to him is, strictly speaking, a receipt of money or property. We are rather concerned with the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the mortgage exactly as if they were his personal obligations. . . . If he transfers subject to the mortgage, the benefit to him is as real and substantial as if the mortgage were discharged, or as if a personal debt in an equal amount had been assumed by another. 8


In a footnote, the Court noted:

Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case. 9


In Tufts, 10 the Supreme Court decided the case posited in the Crane footnote. Tufts acknowledged and developed one of the subplots relating to basis: the inclusion of untaxed borrowings in basis despite the fact that the borrower has no risk of loss because he or she has no personal liability, and the security for the loan is worth less than the amount of the debt. In Tufts, the Court took note of the economic reality that when a borrower obtains funds on a nonrecourse basis, the lender has the full risk of loss. A footnote to the Tufts decision explains:

The Commissioner might have adopted the theory, implicit in Crane’s contentions, that a nonrecourse mortgage is not true debt, but, instead, is a form of joint investment by the mortgagor and the mortgagee. On this approach, nonrecourse debt would be considered a contingent liability, under which the mortgagor’s payments on the debt gradually increase his interest in the property while decreasing that of the mortgagee. . . . We express no view as to whether such an approach would be consistent with the statutory structure and, if so, and Crane were not on the books, whether that approach would be preferred over Crane’s analysis. We note only that the Crane Court’s resolution of the basis issue [i.e., including nonrecourse debt in cost basis] presumed that when property is purchased with proceeds from a nonrecourse mortgage, the purchaser becomes the sole owner of the property. . . . The nonrecourse mortgage is part of the mortgagor’s investment in the property, and does not constitute a coinvestment by the mortgagee. 11


The Court also acknowledged that “the Commissioner’s choice in Crane ‘laid the foundation stone of most tax shelters,’” citing an article by Boris Bittker. 12 The Court noted that Congress acted to curb shelter activity by enacting Sec. 465 to stop a taxpayer from taking “depreciation deductions in excess of amounts he has at risk in the investment.” 13

The Crane court had justified its decision based on two theories that were not adopted by the Court in Tufts. First, the Crane court noted that the taxpayer had obtained an economic benefit from the purchaser’s assumption of the mortgage—a benefit that was identical to that conferred by the cancellation of personal debt. Given the facts of Tufts, however, in which the asset securing the debt was under water, the Court was obliged to abandon this justification for treating relief of nonrecourse debt as included in the amount realized when the property securing the debt was transferred. 14

Second, the Crane court reasoned that the taxpayer had taken advantage of depreciation deductions relating to its basis, a tax-benefit analysis. In contrast, the Tufts court reasoned that its analysis applies even when the taxpayer has taken no deductions for the basis and that a tax-benefit analysis was not necessary to explain its conclusion. 15

Instead, in Tufts the Court agreed with the reasoning in Crane that if nonrecourse debt is included in basis, it is necessary to treat the amount realized in the same manner—by including the full amount of the nonrecourse debt. 16 The Tufts Court held that “a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis.” 17

There is an interesting subplot in this story. In her concurring opinion in Tufts, Justice O’Connor argued that a better approach to nonrecourse debt would be to treat the loan retirement and the security disposition as two separate transactions on the grounds that the Code treats different sorts of income differently: Gain on the disposition of the property may qualify for capital gains treatment, and cancellation of indebtedness is ordinary income. Nevertheless, Justice O’Connor agreed that the IRS took the position espoused by the majority in Tufts and that “it is difficult to conclude that the Commissioner’s interpretation of the statute exceeds the bounds of his discretion. . . . One can reasonably read § 1001(b)’s reference to ‘the amount realized from the sale or other disposition of property’ to permit the Commissioner to collapse the two aspects of the transaction.” 18

As a result of the approach taken by the IRS and the majority in Tufts, there is now a world of uncertainty in characterizing income or gain realized when debt is the subject of a foreclosure transaction. 19 The character of debt as recourse or nonrecourse has significant tax consequences, but there is little guidance on how individual debts should be classified when they have characteristics of both types of debt. What is not uncertain, however, is that both recourse and nonrecourse debt can give rise to basis if the debt is valid indebtedness.

Basis and the S Corporation

Example 3: A borrows $1600x on a nonrecourse basis and acquires the rest of the land from the seller. She then decides to form an S corporation (B Inc.) in order to proceed with development of the land. Two of A’s relatives (Aunt C and Uncle D) join with A in forming B Inc. A contributes the land (subject to the debt) in exchange for 50% of the stock in the S corporation. C and D contribute $200x each for 25% of the stock. B Inc. borrows $200x each from C and D and borrows $800x from a bank. In its first year, B Inc. reports total net losses from operations of $1600x. A, C, and D are anxious to use those losses to offset other income for tax purposes. They understand that special rules apply for an S corporation.


First, it is necessary to determine the investors’ initial basis in B Inc. as well as the corporation’s basis in its assets. Generally, under Sec. 351, no gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock and if immediately after the exchange the transferors are in control of the corporation (as defined in Sec. 368(c)). Thus, A, C, and D can transfer property and cash to B Inc. in exchange for all of the corporation’s stock without immediate tax consequences. Under Sec. 362(a), B Inc. will have a basis in the land contributed by A that is equal to A’s basis in the land ($2,000x) and full basis in the cash contributed by C and D ($200x each). 20

With respect to stock basis, under Sec. 358(a) C and D will have a basis in their stock equal to their basis in the cash contributed. A’s basis in her stock will also be determined under Sec. 358, but for A there is a twist. Under Sec. 358(a), A’s initial basis in the stock will be equal to her basis in the land she contributes to B Inc. Under Sec. 358(d), however, that initial basis will be reduced by the liability to which the contributed property is subject. Thus, C and D will have a cost basis in their stock of $200x under Sec. 358(a)(1), and A will have basis in her stock of $400x, an amount that does not reflect her original cost basis in the land. She loses all her cost basis attributable to the debt incurred to purchase the land. In this case, A’s stock basis reflects her net equity value in B Inc. This twist brings us back to Mrs. Crane’s argument that she should be treated as owning only the net equity in the property she inherited. 21

Basis in S corporation stock is important for a number of reasons. It allows the shareholder to pass through losses and deductions generated by the S corporation and allows the shareholder to receive distributions tax free under Sec. 1368. 22 Basis is generally determined as of the end of the S corporation’s tax year (Regs. Sec. 1.1367-1(d)) and is adjusted for items of income, loss, and deduction at that time.

Under Sec. 1366(a)(1), each shareholder is allocated a pro-rata share of each item of the corporation’s income, gain, loss, and deduction. S corporations cannot make special or disproportionate allocations. As a result, A will be allocated 50% of all losses ($800x), and C and D will each be allocated 25% of the losses ($400x each). The losses will reduce the shareholders’ stock basis by $400x for A and $200x each for C and D. Each of the shareholders will then have a zero basis in the stock of B Inc. C and D also have debt basis, however, so they have access to more losses.

Debt Basis in an S Corporation

Under Sec. 1366(d)(1), a shareholder in an S corporation can take into account losses and deductions passed through by the S corporation that do not exceed the shareholder’s adjusted basis in his or her stock and the shareholder’s adjusted basis in any indebtedness of the S corporation to the shareholder. Sec. 1366(d)(1) makes it clear that the only debt basis taken into account for this purpose is indebtedness of the S corporation to the shareholder. In other words, nonshareholder debt does not provide debt basis to the shareholder for purposes of passing through losses and deductions. Thus, the debt of the S corporation to the bank does not provide any of the shareholders with debt basis. Nor does a guarantee of corporate debt by a shareholder provide debt basis to the shareholder under Sec. 1366. For example, in Raynor, 23 the court held that a shareholder does not obtain basis for a guarantee (despite having a liability under the guarantee) until payment is actually made. 24 Courts have also denied basis when the shareholder is a co-borrower with the S corporation on a loan. 25 The ostensible purpose of this rule is to limit the taxpayer’s ability to use losses and deductions to the taxpayer’s “investment” in the S corporation 26 as reflected in taxpayer contributions and loans to the corporation. 27

Therefore, under the rules applicable to S corporations, A, C, and D will each have the same basis for purposes of losses and deductions ($400x). C and D each have an additional $200x of basis in indebtedness of B Inc. to each of them individually and will be able to have an additional $200x of losses pass through to them from the S corporation. At the end of the year, A, C, and D will have zero stock basis, C and D will have zero debt basis, and each of the shareholders will have $400x of losses that passed through from B Inc. A will have suspended losses of $400x under the rules of Sec. 1366(d). The suspended losses would be carried forward indefinitely under Sec. 1366(d)(2) for A’s use if she were to obtain additional basis in B Inc.

A could obtain additional basis in a number of ways. She could contribute more money to B Inc.; the S corporation could begin to make money and allocate net income to A and the other shareholders; or she could lend money to B Inc. Certain approaches are not open to A, however. She cannot obtain debt basis by guaranteeing the bank debt or the nonrecourse debt to which the land is subject, 28 and she cannot obtain basis by contributing an IOU to the S corporation. 29

Back-to-Back Loans

At this point, A may be thinking that she should have consulted her tax adviser as well as her banker. A could have structured her acquisition of land and stock in a manner that would have given her more basis for purposes of taking losses. For example, she could have contributed her inheritance ($400x) to B Inc. in exchange for 50% of the stock and borrowed $1600x from the bank. A could then have lent the borrowed funds to B Inc. B Inc. could have used its cash to purchase the land for $2,000x. Under these circumstances, A would have stock basis of $400x, and, assuming the transactions are properly documented and the substance of the arrangement is consistent with its form, she is likely to have basis in indebtedness of the S corporation of $1600x. Under these circumstances, A would not have any suspended losses after the first year of B Inc.’s operations and would have $1200x of remaining debt basis.

This approach is termed a back-to-back loan, which in the S corporation context has caused some tax uncertainty. In a back-to-back loan, a shareholder borrows the funds and then lends them to the S corporation. A number of courts have approved back-to-back loan arrangements where the loans are valid debt and the shareholder documents them appropriately and makes payments in a manner that is consistent with the loan documents. Therefore, if A had borrowed the funds from a bank, had documented the loan from the bank and the loan to B Inc. appropriately, and all payments were made in accordance with the loan documents (i.e., from B Inc. to A and from A to the bank), it is likely (although not certain) that under current case law A would have debt basis in her loan to the S corporation.

For example, in Raynor, the court allowed the shareholder basis for borrowed funds that the shareholder then lent to the S corporation. In Gilday, 30 the shareholder obtained basis when he exchanged his note for the S corporation’s note with the lender bank. Nevertheless, the IRS has successfully attacked back-to-back loans in certain circumstances. The courts have found that a shareholder cannot claim basis credit where there is no actual economic outlay. This is most frequently the case where there are related-party debt restructurings that the taxpayer intends to create basis and where the form of the transactions is not consistent with the substance the taxpayer claims. 31

Restructuring existing debt increases the risk that the shareholders’ new debt basis will not be respected under Sec. 1366(d). In Oren, 32 the court did not accept a circular flow of cash that the taxpayers intended to create basis because no one’s economic position was changed in the process. 33 In Kaplan, 34 the taxpayers accomplished the circular cash flow with a third-party bank, and the court disregarded the restructured loans. In Kerzner, however, the shareholder borrowed from a bank and contributed the proceeds to the S corporation, which then paid the proceeds to related entities, and the related entities lent the proceeds to the shareholder to repay the original bank loan.

Thus, the story of basis comes full circle. Properly structured, the cost basis in the land (partially funded by debt) can be reflected in A’s S corporation basis (also partially attributable to debt). However, as was previously noted, basis can be elusive and can disappear if not carefully watched.


As A’s story shows, basis may provide a summary of the tax impact of past events, but that tax impact is not intuitively obvious or logically consistent in many situations. Congress has seen fit to provide special rules to trace a taxpayer’s investment through nonrecognition transactions (by replicating basis of contributed property in the stock received) but also to avoid loss duplication (when basis would ordinarily replicate in a nonrecognition transaction) and provide unique rules for measuring a taxpayer’s investment in an S corporation. Once basis is determined under these rules, A’s next hurdle is to determine if she can actually use the losses generated and passed through by B Inc. A must also navigate the at-risk rules of Sec. 465 and the passive activity rules of Sec. 469. (The at-risk rules will be discussed in the July issue.)

This article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. Copyright © 2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.


1 Anderson, “Federal Income Tax Treatment of Nonrecourse Debt,” 82 Colum. L. Rev. 1498 (1982), citing Surrey, Warren, McDaniel, and Ault, Federal Income Taxation 391 (1972).

2 See, e.g., T.D. 9475 and commentary; Zhu, “Basis Disappearance in All-Cash D Reorganizations,” 126 Tax Notes 950 (February 22, 2010).

3 Princeton University, Wordnet 3.0,

4 Back-to-back loans raise the issue of whether borrowed funds can create debt basis, a special kind of basis in an S corporation. The considerations relating to back-to-back loans are addressed later in this article.

5 Estate of Franklin, 544 F.2d 1045 (9th Cir. 1976); Pleasant Summit Land Co., 863 F.2d 263 (3d Cir. 1988).

6 Old Colony Trust Co., 279 U.S. 716 (1929); Hendler, 303 U.S. 564 (1938).

7 Crane, 331 U.S. 1 (1947).

8 Id. at 14.

9 Id., n. 37.

10 Tufts, 461 U.S. 300 (1983).

11 Id. at 308, n. 5.

12 Bittker, “Tax Shelters, Nonrecourse Debt, and the Crane Case,” 33 Tax L. Rev. 277, 283 (1978).

13 Tufts at 309, n. 7.

14 Id. at 311, n. 11 (“Although the economic benefit prong of Crane also relies on a freeing-of-assets theory, that theory is irrelevant to our broader approach”).

15 Id. at 310, n. 8 (“Our analysis applies even in the situation in which no deductions are taken. It focuses on the obligation to repay and its subsequent extinguishment, not on the taking and recovery of deductions”).

16 Crane at 13.

17 Tufts at 313.

18 Id. at 320 (emphasis added).

19 See, e.g., Cuff, “Indebtedness of a Disregarded Entity,” 81 Taxes—The Tax Magazine No. 3 (March 2003).

20 Sec. 362(a). We assume that the FMV of the land A purchased equals at least its basis at the time of contribution to B Inc.

21 See Regs. Sec. 1.358-3(b), Example (1).

22 In this case, B Inc. has never been a C corporation and has no earnings or profits. As a result, to the extent of the shareholder’s basis in stock, the S corporation can make distributions as a tax-free return of capital under Sec. 1368(b)(1).

23 Raynor, 50 T.C. 762 (1968).

24 See also Rev. Rul. 75-144, 1975-1 C.B. 277.

25 See, e.g., Maloof, 456 F.3d 645 (6th Cir. 2006).

26 S. Rep’t No. 1983, 85th Cong., 2d Sess. 2209 (1958).

27 The rules relating to debt basis in an S corporation are much more restrictive than those applicable to partnerships. In the case of a partner, Sec. 752 provides partners with outside basis for all debts of the partnership.

28 See, e.g., Raynor, 50 T.C. 762 (1968); Underwood, 535 F.2d 309 (5th Cir. 1976).

29 Rev. Rul. 81-187, 1981-2 C.B. 167. But see Perachi, 143 F.3d 487 (9th Cir. 1998), in which the court allowed the shareholder to obtain additional basis through the contribution of a note where the corporation was at risk of bankruptcy.

30 Gilday, T.C. Memo. 1982-242.

31 See, e.g., Foust, T.C. Memo. 1995-481; Russell, T.C. Memo. 2008-246. For more on economic outlay, see Porcaro and Burton, “Economic Outlay Revisited,” 40 The Tax Adviser 292 (May 2009).

32 Oren, T.C. Memo. 2002-172.

33 See also Kerzner, T.C. Memo. 2009-76.

34 Kaplan, T.C. Memo. 2005-218.


Jeanne Sullivan is a senior manager with KPMG LLP in Washington, DC, and is a member of the AICPA’s S Corporation Technical Resource Panel. For more information about this article, contact Ms. Sullivan at

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