What is cost basis in real estate?

Cost basis is the total amount you’ve invested in a property for tax purposes, starting with what you paid and eligible closing costs. You use cost basis to determine your profit or loss when you sell and to calculate yearly depreciation for rental or business property. Improvements can increase your basis, while items like depreciation or casualty-loss deductions can reduce it.

Key takeaways:

• Cost basis is the amount you paid for a property, plus or minus certain adjustments.
• Your cost basis for a home will affect how much capital gains tax you pay when selling it.
• If you use a home as a rental property, cost basis also influences any deductions you take for depreciation

Original cost basis vs. adjusted cost basis

Cost basis represents the amount of money you’ve invested in a property, which can change over time.

It’s important to understand the difference between original and adjusted cost basis.

Original cost basis is easier to calculate. It’s simply the amount you paid for the home, plus certain allowable transaction costs, such as legal fees, surveys, and title insurance.

So, what is adjusted cost basis in real estate? It’s the amount of your original cost basis, plus the cost of capital improvements to your home, minus casualty loss amounts or other decreases.

For example, if you bought a home for $400,000, then spent $100,000 making an addition, your original cost basis would be $400,000, while your adjusted cost basis would be $500,000.

Why cost basis matters when you sell a property

The cost basis is important in real estate for tax purposes.

Cost basis and capital gains tax

When you sell a property, you need to pay capital gains taxes on any profit you earn. To determine your profit, you need to know the cost basis of the property.

Any capital gains tax you owe when you sell your primary residence is determined by subtracting your adjusted cost basis from your profit. There also are capital gains tax exemptions on the first $250,000 in profit from selling your primary home if you’re filing as a single taxpayer and the first $500,000 if you’re married and filing a joint tax return. To qualify for the exemption, you must meet an ownership and use test.

Cost basis and rental-property depreciation

Another way cost basis affects taxes is through depreciation, one of several tax benefits of owning rental property. People who own an investment property often depreciate the value of their property, letting them write off a portion of their income on their tax returns, which affects how rental income is taxed overall.

The cost basis of a property influences how much rental-property depreciation you can deduct on your taxes. Formulas for determining the precise amount you may deduct are complex, but rely on your cost basis and, in general, you may not take any further depreciation deductions, even if you still own the property, once your total depreciation deductions equal your cost basis in the property, which also shapes any capital gains on a rental property when you sell.

How to calculate adjusted cost basis in real estate

The formula to calculate adjusted cost basis is:

Purchase price + eligible closing costs + capital improvements − depreciation and other basis reductions

Keep in mind that depreciation deductions only apply to investment properties.

Real estate cost basis worksheet and calculator inputs

If you want to find your own adjusted cost basis, use this adjusted cost basis calculator and fill in these blanks to run the calculations.

Add the following:

• Purchase price
• Abstract fees (abstract of title fees)
• Charges for installing utility services
• Legal fees
• Recording fees
• Survey fees
• Transfer taxes
• Owner's title insurance
• Any amounts the seller owed that you agree to pay
• Settlement costs

Subtract the following:

• Depreciation
• Casualty losses
• Other deductions

How cost basis changes with inherited or gifted property

Inherited or gifted property is treated differently when it comes to determining taxes. The value is generally updated on the day the gift or inheritance is received.

Cost basis and inherited property

When it comes to inherited property, the basis in the home is often the fair market value at the time of death of the person passing down the property — known as a step-up in basis — based on tax records if an estate tax return was filed, and based on an appraisal if it wasn’t.

If you’re a surviving spouse, it works slightly differently. The portion of ownership you receive from your partner is adjusted on the date of their death. The basis for your portion of ownership is the same as the day you bought the house, so adding the two together gives you your new basis.

The exception to this is in community property states, where the value of the home becomes the cost basis for the property on the day of a spouse’s passing, as long as at least half the value of the property interest can be included in the estate.

Cost basis and gifted property

Gifted property has several tax implications. The person giving the gift typically pays any gift tax that is owed. Generally, the receiver’s cost basis is the donor’s adjusted basis at the time of the gift, with a couple of exceptions:

• If the donor’s adjusted basis is more than the fair market value of the home, you use the fair market value of the home as your basis in any sale.
• If the donor paid the gift tax and their adjusted basis was less than the home’s fair market value, the amount of federal gift tax is added to the adjusted basis.

For investors, there may be an advantage to giving away rental property. While there are gift tax implications, depreciation recapture doesn’t get triggered based on the transfer, which could result in a lower tax bill.

How to prove your cost basis

You’ll need to prove cost basis when you sell your home and need to pay capital gains taxes or want to depreciate a rental property — the IRS will want documentation and proof of your claimed cost basis so it can ensure you’re paying the right amount of tax.

Records that may support your cost basis

The most important records to support cost basis are your purchase and closing documents from when you bought the home. These will outline the price you paid as well as how much you paid for closing costs, such as survey fees, that all contribute to your cost basis.

If you’re adjusting your cost basis, you’ll want receipts and invoices for materials and labor purchased for work done on your home. If you need to account for reductions in your cost basis, records from insurance claims and casualty losses, as well as amounts paid by your insurance company, will be key.

What to do if you have incomplete records

Many people wind up owning their home for a long time, so it’s understandable that you could misplace certain records or receipts or simply forget about certain things that could influence your cost basis.

While it’s best to try to keep your records safe and accessible so you don’t wind up in this situation, you can often find some records online, such as by checking your local government registry of deeds to confirm the purchase price of your home or the permitting office to find the cost of certain improvements.

Be sure to consult a tax professional who can help you determine what you might be able to find that could help if you’re facing a complicated tax situation or incomplete records.

Examples of calculating cost basis in real estate

Michelle bought her home 3 years ago for $180,000, paying $6,000 in eligible closing costs. She added a mother-in-law suite for $50,000. She had a $10,000 insurance claim to cover the roof replacement. The current worth is $450,000. What’s the cost basis?

In this case, the formula for determining cost basis is:

Original sales price + Eligible closing costs + Improvements - insurance claims

$180,000 + $6,000 + $50,000 - $10,000 = $226,000

Cost basis example for an investor

Richard and his two daughters purchased a condo building with eight units 15 years ago for $500,000. The property is now worth $2 million, reflecting their return on investment in the property. They took the maximum allowable depreciation. What’s the cost basis?

In this case, your cost basis formula is:

Original sales price – Depreciation

The key in this case is to be able to calculate depreciation. There are multiple ways to do this, depending on the formula used. However, let’s assume Richard and his daughters used the general depreciation system, employing a straight-line convention. The amount of yearly depreciation you can take is the original sales price divided by 27.5.

$500,000 ÷ 27.5 = $18,181

Next, you multiply the maximum yearly depreciation by the number of years you’ve owned the property.

15 × $18,181 = $272,715

To determine cost basis, subtract the current depreciation from the original value.

$500,000 - $272,715 = $227,285

Cost basis example for gifted property

Isaiah’s older brother, Isaac, gifted him a lake house that was initially purchased for $215,000. There were $6,450 in eligible closing costs. It has a porch for which Isaac originally paid $20,000. Isaac paid the gift tax. At the time of the gift, it was worth $630,000.

Since the property has gone up in value since Isaac bought it, Isaiah’s cost basis is Isaac’s adjusted cost basis in the home:

Purchase price + eligible closing costs + improvements

Substituting in the numbers:

$215,000 + $6,450 + $20,000 = $241,450

FAQ

Here are answers to common questions about cost basis in real estate.

How does the IRS verify cost basis in real estate?

In general, the IRS relies on supporting records such as purchase and sale agreements, receipts, and insurance claims to determine the proper cost basis for a property. Consider working with a tax professional if you need help verifying the cost basis of your home.

How much capital gains tax do you pay on $100,000?

How much you pay in capital gains tax if you earn a $100,000 profit on a home sale can vary widely. It depends on your tax bracket, whether you qualify for any deductions or exemptions, and other factors.

How do casualty losses affect the cost basis of a property?

Casualty losses, such as from disaster or theft, can reduce the value of your home and reduce its cost basis. Work with a tax professional who can help you determine how casualty losses may affect your tax burden.

How does adjusted cost basis affect depreciation recapture?

When you sell an investment home that you’ve depreciated, the IRS will generally recapture that depreciation. For example, if you buy a home for $200,000, take $50,000 in depreciation deductions, and then sell it for $250,000, you might pay taxes on a gain of $100,000 rather than just $50,000.

If you’ve adjusted your cost basis in the home in other ways, that can make depreciation recapture more complex. Consider working with a tax professional who can help walk you through your specific situation.

The bottom line on what is cost basis in real estate

Cost basis is the amount of your capital investment in an asset. It’s important to understand this because it’s the amount your capital gains tax is based on when you sell your home, prior to accounting for any exemptions.

If you’re ready to sell your current home and find your next one, get started with Redfin¹. You can also start your mortgage application online with Rocket Mortgage.

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