Cost basis in real estate can have a big impact on your tax obligations. If you’re buying property, understanding your cost basis ahead of time can help you prepare for the potential tax implications of a sale.
Let’s take a closer look to see how the cost basis in real estate could affect your tax bills.
What Is Cost Basis In Real Estate?
Cost basis in real estate can be thought of as the total cost of buying and owning a property. Knowing the cost basis of your home is important for tax purposes because when you sell your home, you’ll have to pay capital gains taxes on any money above what you initially paid for the property, subject to certain limitations.
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Why Is Cost Basis In Real Estate Important?
Cost basis in real estate is important for determining what you might owe in taxes for a future sale of your property. Essentially, it serves as a baseline for the property owner. If they sell the property for more than the cost basis, they are on the hook for taxes for the difference.
As a homeowner, or anyone selling a house, the cost basis can really impact your tax obligations. The Internal Revenue Service (IRS) will use the cost basis to determine how much profit the seller makes on the sale of a property. If you’ve sold for a large profit, you may have a big tax bill heading your way.
What’s Included In A Property’s Cost Basis?
The cost basis is most important when a property is sold. At that point, it’s used to determine your capital gains tax obligations. It’s important to keep track of the cost basis of a property throughout your ownership.
Here’s a look at what’s included in a property’s cost basis:
- The price you paid for the property: The purchase price of the property is a starting point.
- Recording fees: Recording fees you paid as a part of your closing costs must be included.
- Other legal fees: Legal fees required as part of your closing process can be included.
- Seller debts being paid by the buyer: In some cases, you’ll pay off seller debts to acquire a property. Those costs can be included in the cost basis. Speak with a tax professional for more details.
Factors That Affect Cost Basis
In some cases, the cost basis is simple to calculate. But in special situations, the calculations change. Here’s how the cost basis can change based on how you acquire the property:
Cost Basis For Inherited Properties
If you inherit a property, the cost basis generally depends on the original owner’s time of death. The cost basis is usually the fair market value when the property passes from the original owner to you. Fair market value is considered the cost a property would sell for in an open market between unrelated parties.
Cost Basis For Gifted Properties
If you receive a property as a gift, the donor won’t receive the fair market value as compensation.
The giftee can use the donor’s adjusted basis – which we’ll cover below – when they sell the property for a gain. If the giftee sells the property at a loss, then the basis can be either the donor’s adjusted basis or the fair market value when the gift changed hands.
Cost Basis For Investment Properties
Investors use their cost basis to depreciate a property and reduce their taxable income for the year. Depreciation is an important tool that allows real estate investors to deduct part of the cost of buying and improving a property over the time they own it. Like other property owners, the original cost basis is the amount paid to acquire the property, plus fees and the cost of any improvements. But with depreciation, the investor can reduce their cost basis over time.
At some point, investors may sell the property and encounter a depreciation recapture. Essentially, this means a bigger tax bill, unless you can defer your tax bill with a 1031 like-kind exchange. Speak to a tax advisor about the best way to handle depreciation for your investment property.
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Adjusted Basis In Real Estate
An adjusted basis refers to a cost basis that changes over time. Depending on your property’s situation, there are many reasons for an adjusted basis.
Here are a few factors that could increase your cost basis:
- Home improvements or additions: Home improvements that increase the value of the home will add to your cost basis.
- Legal fees related to the property: Legal fees necessary to keep the property running smoothly will boost your cost basis.
Here are a few factors that could lower your cost basis:
- Depreciation: Investors use deprecation to lower their taxable income, and income taxes, for the year. This leads to a lower cost basis.
- Receiving insurance payouts for a claim: Claim payouts for theft loss or casualty put money in your pocket and lower the cost basis.
- Tax credits for select home energy upgrades: The right home energy upgrade comes with a tax credit, which counts against your cost basis.
Of course, these are just a few scenarios. If you have questions about a specific situation, it’s best to consult a tax professional. They can map out the most streamlined cost basis for tax purposes.
How To Calculate Cost Basis For Real Estate
The cost basis of a property has critical tax implications, so you’ll need to know how to calculate it before you file your taxes. Let’s take a look at an example of how cost basis is calculated in the real world:
Let’s say that you purchase a property as a primary residence for a purchase price of $250,000. Over the years, you put in another $50,000 worth of home improvements, such as a new bathroom and kitchen. Those upgrades increased your adjusted basis to $300,000.
At some point, you put $5,000 of solar panels on the roof. But a tax credit of $5,000 made this transaction a wash in terms of cost basis. With these costs, your current cost basis remains $300,000. After 10 years in the home, you decide to move and to sell your current house. The home fetches a selling price of $500,000 and you still owe $200,000 on the mortgage. This means your capital gains from the sale of your home is $300,000 in profits.
At tax time, you’re normally subject to capital gains tax on the profits of a sale of your home or property. However, if you’re a homeowner that has lived in the home for 2 of the last 5 years, you can exclude up to $250,000 of that gain from your income, or $500,000 if filing a joint return with your spouse.
For the cost basis of your property, it’s a good idea to update the numbers regularly. When an expense impacts your cost basis, clearly document it for future reference. The IRS may need to see specific documentation for all transactions that lead to an adjusted cost basis when it’s time to calculate your capital gains tax obligations. For all of this, it’s recommended to consult a tax professional to ensure that everything is correct and legal.
The Bottom Line
The cost basis in real estate is an important point at tax time. The impacts of cost basis are most important when selling a home. However, it’s critical to understand where your cost basis stands ahead of a sale and to keep track of the adjusted cost basis while you own the property. Otherwise, you could be on the hook for a tax bill that you can’t afford.
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Sarah Sharkey
Sarah Sharkey is a personal finance writer who enjoys diving into the details to help readers make savvy financial decisions. She’s covered mortgages, money management, insurance, budgeting and more. She lives in Florida with her husband and dog. When she's not writing, she's outside exploring the coast. You can connect with her on LinkedIn.
