It is a common misconception that the cost basis for a rental property is the price paid for a property. The cost basis for a rental property is actually the cost of acquiring the property considering not just the price, but also expenses incurred in the sale.
The cost basis is important because it helps determine what you will need to report as taxable income.
Calculating Cost Basis
The steps for calculating the cost basis of a rental property are the same regardless of how you paid for the property.
Original Cost of the Investment
First, you need to know what you paid for the property. This is the total amount of your loan or how much cash you paid.
Costs Related to Acquisition of the Property
Next, you take the price you paid for the investment and add certain expenses related to the purchase of the property. Some of these items include:
Closing Costs - not all closing costs are added to the cost basis. Only closing costs you pay can be included, not any paid by the seller. In addition, any costs that are otherwise deducted on income taxes, like loan origination fees and prorated interest, are not included in the basis.
Costs related to the purchase of the property that might be added to the cost basis include:
- Settlement costs
- Title search
- Title insurance
- Recording fees
- Realtor’s commissions
- Appraisal fees
- Transfer taxes
The IRS provides a full list of closing costs that are added to the cost basis of your property.
Improvements made to the rental property beyond the initial purchase price might also be added to the cost basis. The items should be physical improvements that an appraiser would likely say increase the value of the property. Some examples include:
- New roof
- Kitchen remodel
- New HVAC system
So, taking the above information let’s look at the cost basis for a rental property that was purchased for $200,000. The qualifying closing costs are $10,000 and a full bathroom remodel was $7,000. This would mean the cost basis for the property would be $217,000.
The calculation of a rental property’s cost basis is not an exact science and has many variables. If you have questions it is important to contact a tax advisor.
Cost Basis for Calculating Depreciation
When determining the basis for calculating depreciation, the cost basis of the land and building need to be calculated separately. Unlike the building structure, land doesn’t depreciate. So, the value of the land and the value of the actual housing structure should be looked at individually.
Using a property tax assessment is one way to calculate the difference between the cost basis of the land and building separately.
For instance, if you have a property with a combined land and structure cost basis of $150,000. The tax assessment says that 30% of the property value is the land and the other 70% is the building. You would use 70% of $150,000 as the cost basis for calculating depreciation.
It is surprising how many investors miscalculate the cost basis, and so it is always beneficial to talk with a financial advisor to make sure calculations are accurate for tax purposes.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.