What Types Of Costs Can Be Included In The Initial Cost Basis?

In the realm of real estate, calculating the cost basis of a property incorporates more than just the purchase price. It's a comprehensive value that includes the initial amount paid for the property, closing costs borne by the buyer, as well as expenses linked to any improvements made on the property (excluding any associated tax credits). Simply put, your cost basis is the original price paid plus all these additional costs, providing a more accurate depiction of your true investment in the property. 

Why does the cost basis amount matter?

Determining an accurate cost basis does matter for investors, often significantly. First, the cost basis is a more realistic representation of the investment amount than the price alone. If you buy a property for $500,000, but you have $100,000 in closing costs and other acquisition expenses, and then you spend $200,000 improving the property, your cost basis is $800,000, not the $500,000 sales price. 

Having an accurate basis is crucial if you later sell the property. The basis is a starting point for your sales price, plus it is the amount that determines how much you may owe in capital gains taxes. Using the example above, suppose you buy the property for $500,000 and sell it for $1,000,000. If you fail to include the acquisition and improvement costs, you could owe capital gains taxes on $500,000 instead of $200,000.

What is included in the cost basis of the property?

The most significant element in calculating cost basis is the purchase price. Other additions may include these:

• Unpaid real estate taxes. Typically, the seller would pay back taxes at closing, but if you pay them as the buyer, they are added to the cost basis.
• Closing costs are the expenses of buying and financing a property. These charges are common additions to the closing cost subtotal:
  • Title fees and title insurance
  • Legal fees
  • Recording fees
  • Transfer taxes
  • Survey expenses
  • Utility installation
• Construction and other improvement costs, including architect expenses, labor and materials, contractor charges, and the cost of obtaining building permits and inspections. 

Your cost basis may be adjusted by other expenses, depending on the building’s use and needs. In general, the additions to the purchase price are any expenses directly related to the acquisition and development of the property. 

How does the cost basis affect depreciation?

As with capital gains calculations, a higher cost basis matters when determining your depreciation allowance. Depreciation is how taxpayers allocate the asset’s cost over time. Investment property owners can deduct the asset's price over the course of 39 years in most cases. The IRS established this time frame to account for the diminishing utility of property improvements. The land cost is never included in depreciation allowances, but acquisition costs are. Again, using the previous example, note the difference between claiming depreciation on $500,000 versus $800,000. The $500,000 purchase price deduction over 39 years is $12,820. In comparison, the depreciation amount for the adjusted basis of $800,000, including the acquisition costs, is $20,512 yearly. 

Keep in mind that when the investor sells the property, the IRS will expect repayment of a portion of the amount deducted using depreciation. This depreciation recapture expense, like capital gains taxes, can be deferred using a 1031 exchange to dispose of the property.