Tax Basis in Real Estate Part 1 - What is Basis?

One of the first questions, and frankly one of the most important, I typically ask real estate owners who are considering or are in the midst of a 1031 exchange is “what is your adjusted basis in the property being sold?” I dare say that 95 percent of the real estate owners I speak with on a daily basis don’t know the answer to this question.

Why is it important? The simple answer is that this number determines what a seller’s capital gains tax liability is going to be. The first decision in any 1031 exchange should always be whether an exchange is even necessary; and this decision can’t be made until a good estimate of the potential tax liability is determined. I see it so often where sellers believe that if they sell a property for $600,000 and pay off a $200,000 mortgage, leaving $400,000 in cash at closing, they assume the taxes owed would be based on the $400,000. In reality, the capital gains taxes are based primarily on the $600,000 less their adjusted basis in the asset.

I think the reason most people don’t have a good handle on the adjusted basis number is confusion as to all the terms involved, how exactly adjusted basis calculated, and the fact that the adjusted basis changes over time so keeping up with the records can prove difficult.

Basis

In simplest terms, “Basis” is the amount your property is worth for tax purposes. Where the confusion comes in is that the Basis changes over time, and thereby becomes known as “Adjusted Basis”.

Cost Basis

“Cost Basis” is the starting point. In fact, many CPAs refer to it as “Starting Basis”. It represents what you initially paid for your property, including certain extra costs you incurred when buying the property like title insurance, appraisal fees, escrow fees, lawyer fees, document fees. When determining Cost Basis, the purchase price shown on the closing statement is where you start. If you buy a property with a purchase price of $300,000 and used cash of $100,000 and a mortgage of $200,000 at closing, the starting point for your Cost Basis is $300,000. Add to that certain incidental costs incurred to close on the transaction and you have your Cost Basis.

Adjusted Basis

“Adjusted Basis” and “Basis” are terms often used interchangeably by CPAs and tax professionals. It represents the Cost Basis that has been adjusted over time either through increases and/or decreases to basis. The most common, and often the largest, adjustment included is depreciation. To the extent you claim depreciation deductions on your tax returns for a given property, you decrease the adjusted basis in the property for these amounts. The most common increase in basis is making capital improvements to the property such as new roofs, adding rooms, or repaving the driveway.

The table below gives some common examples of items that increase or decrease your adjusted basis.

In the next article in this series, I’ll dive into more detail as to what types of costs and expenses can be included in the “Cost Basis”. In the meantime, if you’re up for some light reading and want to more information on basis and adjusted basis, refer to Publication 551 and the Form 1040, Schedule D Instructions, Capital Gains and Losses from the IRS.

Need help determining your potential tax liabilities from the sale of an investment property? Want to better understand your options and limitations? Realized will prepare a 1031 Investment Plan, which among other valuable analysis, will estimate your potential tax liability and help you determine if a 1031 exchange is your best option.* With nearly 60 years of collective experience and $5.0 billion of real estate transactions behind us, the Realized team has the expertise and the tools to assist in understanding the risks and returns of investments. Visit our Marketplace to view a variety of tax-efficient, 1031-qualified real estate investment opportunities. Offerings are pre-packaged, allowing accredited investors to efficiently compare multiple opportunities and create customized portfolios.