Figures: tax year 2026
Debt basis restoration reverses prior basis reductions using a subsequent year's positive net increase. To calculate changes in a shareholder's debt basis, the preparer determines that net increase before allocating basis to a repayment.
The restoration calculation follows:
- Add the shareholder's allocated basis-increasing income items, including taxable income and qualifying tax-exempt income.
- Subtract applicable distributions, nondeductible expenses, losses and deductions, including basis-suspended deductions entering the current-year computation.
- Apply a positive net increase to restore previously reduced debt basis, limited to the remaining restoration capacity.
Cash contributions by the shareholder increase stock basis directly and do not enter income-based restoration. Consequently, routing all gross income or a capital contribution into debt basis overstates restoration.
The restoration computation uses annual tax results and applies only to qualifying debt held at the beginning of that year. For a written note repaid during the year, restoration is effective immediately before its first repayment, even though annual results become known later.
Common mistakes
- Omitting tax-exempt income. Excluding Example 1's interest produces $10,000 + $30,000 + $5,000 - $40,000 - $3,000 = $2,000, understating ending stock basis by $2,000.
- Combining distribution capacity. Adding Example 3's $10,000 stock basis and $12,000 debt basis creates a false $22,000 distribution capacity and improperly treats all $15,000 distributed as tax-free.
- Subtracting the entire repayment. Example 4's $20,000 debt basis minus $10,000 principal payment incorrectly produces $10,000 remaining basis; proportional basis recovery is only $4,000.
Bottom line
- Cash capital contributions and allocated taxable and qualifying tax-exempt income increase stock basis, subject to applicable debt restoration.
- The default reduction order is distributions, nondeductible expenses, then losses and deductions.
- Nondividend distributions use stock basis only; excess distributions produce gain without creating negative stock basis.
- Losses reduce remaining stock basis before qualifying debt basis, and losses exceeding both bases are suspended.
Exam shortcut
Label every cash movement as capital contribution, equity distribution, loan advance, principal repayment, or interest before beginning the arithmetic. Identify accumulated earnings and profits before using the simplified distribution rule. Keep the distribution test above nondeductible expenses and losses in the stock schedule. For repayment questions, place outstanding principal and adjusted debt basis in separate columns. Check for current-year restoration before calculating the basis-recovery ratio.
The full lesson (about 4,505 words, 30 min read) adds 6 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- V.C3
Browse all free CPA REG lessons or jump into free CPA REG practice questions.