A Comprehensive Guide To Cost Basis For Real Estate And How To Calculate It
Scott Steinbergx-minute read
July 23, 2021
What does the term “cost basis” refer to in real estate – and how can you calculate your cost basis in any given property?
It’s a smart question to ask, as your cost basis in real estate holdings effectively determines how much (if any) monies you’ll potentially be expected to pay tax on upon the sale of your property or assets at a later date.
Below, you’ll learn more about how cost basis works – and how to calculate it.
What Is Cost Basis In Real Estate?
Cost basis is essentially defined as the amount that your property is worth from the standpoint of taxation. Upon the sale of a piece of real estate (for example, your single-family home residence) profit or loss is calculated by taking the property’s sales price and subtracting it from your cost basis on the date of sale. In essence, the bigger your cost basis is? The less your ultimate gains (aka profits) will be, and the less you’ll owe come tax time.
Put simply: In real estate, the cost basis is the original value that a buyer pays for their property.
It’s an important figure to know because homeowners who sell a residence or investment property must pay capital gains tax on any monies generated above and beyond what they initially paid for these assets. Think of cost basis as a measuring stick through which the Internal Revenue Service (IRS) will look to determine how much you’ve made in terms of gains on the sale of an asset such as a house, apartment or condo – and, for that matter, what portion of any given real estate property sale that it might hope to collect tax monies on.
An important point to keep in mind here as well: When calculating cost basis for homeowners, the property owner’s cost basis increases by the cost of any capital improvements made to the property. Likewise, for investors, it’s also important to consider that the cost basis is the purchase price of any given property minus depreciation and tax credits. In other words: Cost basis can change over time as well.
To summarize, cost basis value is used in the calculation of capital gains or losses, which is the difference between the selling price and purchase price of your asset (your property).
What Can Be Included In The Cost Basis Of A Property?
According to accounting pros, it’s important to consider your cost basis and how it’s computed as you contemplate a potential sale of your property and how much money you might receive from it. Your cost basis typically includes:
- The original investment you made in the property minus the value of the land on which it sits
- Certain items like legal, abstract, or recording fees incurred in connection with the property
- Any seller debts that a buyer agrees to pay
As noted, your cost basis does not necessarily remain static, especially as time passes. If it changes, it becomes referred to as your adjusted basis.
In effect, your adjusted basis is a figure that takes additional factors into account when computing your capital investment in a property for tax purposes – factors that can add to or subtract from your original cost basis.
Note that this amount can vary depending on how any money relating to your property is spent (like improvements to the property, repairs for damages, etc.) and may also be impacted by factors such as depreciation and insurance payouts. To calculate your adjusted basis:
- Begin by noting the cost of the original investment that you made in your property
- Next, add in the cost of major improvements (for example, additions or upgrades)
- Then subtract any amounts allowed via depreciation or casualty and theft losses
Samples which can reduce your cost basis include:
- Insurance payments received due to a casualty or theft loss
On the flip side, factors which can increase your cost basis include:
- Additions and improvements to the home
- Monies that you spend to restore property after damage or loss
- Tax credits assigned for home energy improvements
- Legal fees spent that relate to the property in question
Homeowners most commonly increase their cost basis by making significant improvements to their property that grows their home’s value, boosts its lifespan, or enables new uses for the property. Common improvements that might increase your cost basis include but are not limited to bathroom or kitchen upgrades, home additions, new roofing, the addition of a fence or desk, and various landscaping enhancements.
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How Cost Basis Changes
Numerous factors – like how you received or purchased a piece of property, whether or not the real estate was gifted, etc. – can impact your cost basis over time.
For Inherited Property Vs. Gifted Property
Inherited property is received upon the death of another party. Cost basis for an inheritance is fair market value at the time of their passing.
Gifted property is given to you by another individual who does not receive full market value in return – it’s received as a gift, such as from a parent to a child.
If a gain is incurred at the time a property is sold in the case of gifted property, the cost basis is the donor’s adjusted cost basis on the home. Should you incur a loss on the property instead, the basis is the lesser of either (a) the donor’s adjusted cost basis or (b) fair market value at the time the gift was made.
A homeowner’s cost basis generally consists of the purchase price of the property, plus the cost of capital improvements, minus any tax credits (like the Residential Energy Credits) that they have received.
Investors can depreciate property to reduce their income in any given year. However, depreciating a real estate property also reduces their cost basis – potentially leading to depreciation recapture and a larger bill at a later date. On the bright side, most investors can avoid paying capital gains taxes by doing a 1031 exchange.
Calculating Cost Basis In Real Estate
By way of example, say Tim purchased a home for $300,000 and sold it 20 years later for $500,000.
During the time that he was the homeowner, he put $30,000 worth of improvements into the property, including a new backyard fence and numerous kitchen and bathroom renovations, which increased his cost basis to $330,000. An insurance company also paid him $10,000 at one point to pay him back for damage to the roof done by an electrical storm – a payment which decreased his cost basis to $320,000.
To calculate how much he might owe taxes upon, Tim subtracts his adjusted cost basis ($320,000) from the home’s ultimate selling price ($500,000) to determine the gain in profits he recognized ($180,000) by virtue of the sale.
But in the event that the property had been gifted to him by his parents or received as an inheritance upon their death … or if he changed the use of the property from a personal residence to a business? Tim’s cost basis would be subject to alternate calculations and adjustments, as discussed above.
The Bottom Line
Cost basis is important because it serves as a starting point (or endpoint in the case of your adjusted basis) for determining any profits (aka capital gains) or losses on the sale of real estate assets. Capital gains tax must be paid on these gains unless steps have been taken to make them subject to exemption.
Bearing this in mind, it’s important to keep track of your cost basis as you make improvements to your home, or depreciate it to maximize short-term tax savings, as it will ultimately determine your basis for taxation at a later date. Likewise, your adjusted cost basis has the potential to wax and wane over time, which may impact how much you owe to the IRS overall.
Looking to learn more about real estate investing and how to minimize capital gains tax? Be sure to continue browsing around our Learning Center.
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