Understanding how to calculate the adjusted cost basis of a rental property is essential to accurately determine its value and potential profits from a sale. Also, the adjusted basis isn't the same as the basis. Once you finish reading this article, you should understand the difference between these two terms and be able to work through calculating the adjusted basis.
What is the Basis?
The basis is the purchase price plus related realtor commissions. The basis is also called the cost basis.
The basis is used to calculate your gain or loss for tax purposes. If your sale price is above your basis, you have a gain. If it is below your basis, you have a loss. Note that on a primary residence, a loss is not deductible.
The higher your basis, generally, the less gain you’ll have. Even if the sales price is higher than you anticipated and if the basis moves up, the gap between the basis and sale price (i.e., gain) will decrease.
Whether you use a loan or not doesn't change the basis; as an example, you purchase a property for $500,000. Financing is made up of $400,000 in cash plus a $100,000 loan. The basis is still $500,000 before related closing expenses are added in, which will adjust the basis up.
Closing expenses can be found on your closing statement. But there may be some expenses that aren’t listed. Check with your realtor or accountant to be sure.
What is the Adjusted Basis?
As expenses are incurred on the property, the basis will change. This is called the adjusted basis. Properties require maintenance and improvements. There is depreciation and insurance to pay. The longer you own a property, the more expenses there are to factor into the adjusted basis calculation.
Related expenses must be factored into the basis as they are an accurate reflection of the investment's value.
Calculating the Adjusted Basis
To calculate the adjusted basis, you first have to know which expenses are eligible to be included in the calculation and if they adjust the basis up or down. Below is a simple guide to help figure out the impact on the basis of various expenses:
- Acquisition costs (i.e., title-related, transfer fees, surveys).
- Cost for additions or improvements.
- Cost of installing utility service.
- Property-related legal fees.
- Restoration cost related to damage or loss due to theft, flood, fire, or other casualties.
- Home energy improvement tax credits received after 2005.
- Depreciation (i.e., home used as rental or business).
- Insurance payouts related to casualty or theft loss.
- Deductible for casualty loss that wasn’t covered by insurance.
- Gain on sales of a home before May 7, 1997.
- Money received for granting an easement.
The following expenses do not affect the cost basis:
- Appraisal fees
- Pest inspection fees
- Credit report fees
- Mortgage broker's commissions
- Loan fees (not points)
Let’s go through an example to understand how the adjusted basis is calculated.
Home purchase price: $500,000
+ Closing cost: $12,500
+ Improvements while occupying home: $100,000
= Adjusted basis: $612,500
Home sales price: $800,000
- Closing cost: $60,000
= Sale Proceeds: $740,000
Now we can calculate the capital gain:
The capital gain on this home is $127,500. That is the amount that will be taxed. The above is just a simple example to give you an idea of how various expenses impact the basis.
Of course, investors are always seeking out methods to shelter gains from taxes. A 1031 exchange allows you to defer gains when exchanging into like-kind property. This includes exchanging into a DST. To ensure your adjusted basis is calculated correctly, it’s always best to work with your financial advisor or accountant. They can also help with decisions on moving forward with a 1031 exchange.