Capital Appreciation and Recovery of Basis under Tax Law

11 Jul 2025 --
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📘 1. Overview

In U.S. tax law, when an asset appreciates in value, the increase is known as capital appreciation. When the asset is eventually sold or disposed of, the recovery of basis and any capital gain must be properly accounted for to determine the tax liability.

📗 2. Key Terms

Capital Appreciation:
The increase in the value of a capital asset over time, from its original purchase price (basis) to its higher market value.

Basis (Tax Basis):
The taxpayer’s investment in the property, generally the cost of the property including certain expenses.

Adjusted Basis:
The original basis, adjusted for various factors like improvements, depreciation, or casualty losses.

Recovery of Basis:
When an asset is sold, the seller first recovers their basis tax-free. Only the amount received in excess of the adjusted basis is considered taxable gain.

Capital Gain:
The portion of proceeds from a sale that exceeds the adjusted basis. Taxable, depending on holding period (short-term vs. long-term).

📙 3. Capital Appreciation: Not Taxable Until Realized

Under the “realization principle”, capital appreciation is not taxed until the gain is realized—i.e., when the asset is sold, exchanged, or otherwise disposed of.

Key Principle: Unrealized appreciation is not taxable income.

📘 4. Recovery of Basis: The First Dollars Are Not Income

When you sell an asset, the IRS allows you to recover your basis first, tax-free.

Example:
Buy stock at $10,000
Sell for $18,000
Recovery of Basis: First $10,000 is not taxed
Capital Gain: $8,000 is subject to tax

This ensures you are not taxed on money you have already invested (your cost).

📕 5. Case Law Supporting These Principles

🧑‍⚖️ 1. Eisner v. Macomber, 252 U.S. 189 (1920)

Holding: The Supreme Court held that mere appreciation in value of property (e.g., stock dividends) is not income unless and until it is realized.

Relevance: Reinforces the concept that capital appreciation is not taxable until a sale or exchange occurs.

🧑‍⚖️ 2. Helvering v. Bruun, 309 U.S. 461 (1940)

Issue: Whether gain from lease termination and building reversion was taxable.

Holding: Gain was realized when the property was returned with added value.

Relevance: Demonstrates that realization, not just appreciation, triggers tax.

🧑‍⚖️ 3. Commissioner v. Tufts, 461 U.S. 300 (1983)

Issue: Tax consequences when property subject to a nonrecourse mortgage is sold.

Holding: Full amount of debt relief is part of the amount realized, even if it exceeds basis.

Relevance: Clarifies how recovery of basis works when liabilities are involved.

🧑‍⚖️ 4. Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991)

Holding: A realization event occurs when there is a "material difference" in exchanged properties.

Relevance: Further supports the realization doctrine as the trigger for gain recognition.

📘 6. Recovery of Basis in Installment Sales

Under IRC § 453, when property is sold on an installment plan, the taxpayer recovers basis proportionately over time.

Formula:
Gross Profit Percentage=Gross ProfitContract Price\text{Gross Profit Percentage} = \frac{\text{Gross Profit}}{\text{Contract Price}}Gross Profit Percentage=Contract PriceGross Profit
Then, for each payment received:
Taxable Gain=Payment Received×Gross Profit Percentage\text{Taxable Gain} = \text{Payment Received} \times \text{Gross Profit Percentage}Taxable Gain=Payment Received×Gross Profit Percentage

📙 7. Special Note: Depreciation and Adjusted Basis

If you depreciate an asset (e.g., rental property), your adjusted basis decreases, and more of the sale proceeds may become taxable gain.

Example:
Buy property for $100,000
Depreciate $20,000 over time
Adjusted Basis = $80,000
Sell for $110,000
Gain = $30,000
(This includes $20,000 of depreciation recapture taxed as ordinary income under §1250)