Adjusted Basis: What It Means And How It's Determined
Victoria Araj3-minute read
July 21, 2021
There are a million and one things every homeowner needs to know before they sell. Between making repairs and running errands, one important subject may have slipped into the background: taxes. The total amount you receive from the transaction, or the amount realized, and the adjusted basis of your home help decide whether your sale is taxable.
The last thing you want during the sale of a property is to be caught off guard by any costs. Here is a brief rundown on what an adjusted basis is and how it impacts your taxes.
What Is Adjusted Basis?
The “basis” of an asset is the cost of its purchase. That includes the original prices as well as any taxes or associated fees that came with it.
Therefore, an adjusted basis refers to the cost of an asset, such as real estate property, after accounting for any increases or decreases to its original value. This value is often used for tax purposes to determine what the asset owner’s capital gain or loss on the sale of that asset will be.
Various factors can alter your asset’s basis. For example, subtracting amounts you claimed as tax deductions, like depreciation, will decrease your basis. In contrast, additions or improvements made to the property increase the basis.
How To Calculate The Adjusted Basis Of A Rental Property
To calculate a rental property’s adjusted basis, you first have to know the original cost. This beginning basis is the purchasing price if you bought the property or the construction price if you built it. Alternatively, if you inherited the property, then its corresponding basis is the asset’s fair market value on the day you acquired it. This is otherwise known as the step-up basis.
Let’s work through an example scenario.
Say you purchase a real property for $400,000. You pay $11,000 in closing costs and make capital improvements to the property worth $13,000. At this point your adjusted basis is $424,000.
But now you want to sell the property. Selling costs also add on to the basis of the property, such as commissions fees and advertising costs. Your overall cost of sale is $9,000. That puts your adjusted basis at $433,000.
Certain factors will reduce that value, however. The property depreciated over the years, which you held for 8 years. Every year you held the property, it depreciated by $10,000. So, your overall depreciation is $80,000. The cumulative $80,000 reduces the adjusted basis down to $353,000. You would also include any additions or improvements that depreciated in value.
Finally, you sell the property for $500,000. That leaves you with a gain of $147,000 (after subtracting the adjusted basis of $353,000 from $500,000).
Keep in mind that a higher adjusted basis may benefit you tax-wise, since it delivers a lower gain. You can adjust the cost basis of your home to reduce your capital gains tax when you eventually sell.
You can increase the original basis of your property by adding on other costs related to the property. In particular, they apply to the buying or building of said real estate. However, these increases to the adjusted cost basis do not account for improvements or additions made to the property. Create separate accounts for them instead and evaluate their impact on the basis’s value accordingly.
Here are some of the items that can increase the overall basis of your real property:
- Legal fees
- Zoning costs
- Impact fees
- Cost to extend utility service lines
- A redeemable ground rent’s capitalized value
Generally, increases to the property’s cost basis decrease your tax burden.
You can adjust your cost basis downward as well. Certain items decrease your cost basis by subtracting associated capitalized costs from the asset’s value. Some of the more usual expenses that reduce an asset’s adjusted cost basis are theft, depreciation, or damage to the asset. However, depletion and amortization can also play into this role.
Here are some of the items that can decrease the overall basis of your real property:
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Using Adjusted Cost Basis To Determine Your Capital Gains And Losses
The projected adjusted basis should influence your decision when buying rental property. In particular, any investor who wants to get into real estate should evaluate an asset’s adjusted basis. Naturally, you want to know what your future gains and losses will look like in any investment.
A property’s basis impacts the amount in taxes you’ll pay. The taxable profit you can make from the asset’s sale, otherwise known as the capital gain, is the leftover difference between the selling price and the basis. If you obtain a larger gain, then you will owe more in taxes. This interrelationship may factor into your decision to sell a property or not.
The Bottom Line
An adjusted basis is just one of the many factors any real estate owner needs to take into account before a property sale or purchase. Once bought, keeping an itemized list of values and expenditures will make it easier for any owner. With that, you can predict the eventual tax implications of your property’s adjusted basis. Learn more about the benefits of real estate investing before diving into any purchases.
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