How Does the IRS Verify Cost Basis for Real Estate?

Determining the cost basis of real estate is essential for calculating capital gains taxes when a property is sold. The IRS requires accurate records to ensure taxpayers report their gains correctly, and discrepancies can lead to audits or penalties. Understanding how cost basis is verified helps property owners maintain proper documentation and avoid tax issues.

Sources of IRS Data

The IRS verifies real estate cost basis using multiple sources. One primary method is third-party reporting through Form 1099-S, filed by title companies, real estate brokers, or attorneys involved in property sales. This form reports gross proceeds, allowing the IRS to cross-check reported gains with official transaction records.

The IRS also reviews property tax records and mortgage documents. County assessor offices maintain historical property valuations, helping establish ownership timelines and value changes. Mortgage lenders provide loan origination and payoff statements, which can sometimes indicate a property’s purchase price.

Financial institution records also play a role. If a property was acquired through a 1031 exchange, Form 8824 tracks the basis carried over from the relinquished property. If purchased with funds from a brokerage account, bank statements and wire transfer records may verify the source and amount of the initial investment.

Documenting Original Purchase or Construction

Establishing cost basis starts with maintaining thorough acquisition records. For purchased properties, the Closing Disclosure or HUD-1 Settlement Statement provides definitive proof, itemizing the purchase price and associated expenses like title insurance, legal fees, and transfer taxes. A copy of the deed and sales contract further substantiates ownership history and financial terms.

For constructed properties, cost basis includes land acquisition, materials, labor, architectural and engineering fees, and permit expenses. Construction loan records, contractor invoices, and municipal permits serve as primary evidence. If the owner acted as their own general contractor, detailed records of payments to subcontractors and suppliers are necessary.

Certain fees and assessments impact the original basis. Special assessments for infrastructure improvements, such as sewer lines or sidewalks, can be added. Impact fees for new developments are also considered part of the acquisition cost rather than deductible expenses.

Tracking Renovation and Improvement Costs

Accurate records of renovations and improvements help adjust a property’s cost basis. Unlike routine repairs, capital improvements—such as room additions, kitchen remodels, or energy-efficient upgrades—can be added. The IRS defines capital improvements as those that increase value, prolong useful life, or adapt the property to new uses (IRS Publication 523).

Proof of these expenditures should be retained in the form of contractor invoices, receipts for materials, and permits. If a homeowner performs the work themselves, material costs and hired labor can be included, though personal labor cannot. Payments made via check, credit card, or bank transfer provide additional verification. These records should be kept for as long as the property is owned, plus at least three years after filing a tax return that includes the sale.

Certain tax credits or deductions affect the adjusted basis. For example, if a homeowner claims the Energy Efficient Home Improvement Credit under the Inflation Reduction Act of 2022, the credit amount must be subtracted. Similarly, insurance reimbursements for property damage that led to an improvement must be excluded from the total cost added to the basis.

Handling Inherited or Gifted Property

Inherited and gifted real estate follow different basis rules. For inherited property, the basis is generally the fair market value (FMV) on the original owner’s date of death, as outlined in the Internal Revenue Code. This “step-up in basis” reduces capital gains tax liability since appreciation during the decedent’s lifetime is not taxed. Executors often obtain a professional appraisal to establish FMV. If the estate is large enough to require Form 706 (Estate Tax Return), the reported valuation serves as the definitive basis.

For gifted property, the recipient assumes the donor’s original basis, adjusted for any gift tax paid if the FMV exceeds the donor’s basis. If the property has significantly appreciated, the recipient may face higher capital gains taxes upon selling it. Documentation such as the donor’s purchase records, depreciation schedules if the property was previously rented, and records of prior improvements must be maintained to determine the correct adjusted basis.

Potential Audits and Review Process

The IRS reviews real estate transactions for discrepancies in reported cost basis, which can trigger an audit. The process typically begins with an automated review, where the IRS cross-references reported sale proceeds against historical data, such as prior tax returns, mortgage records, and third-party filings. If inconsistencies arise, the IRS may issue a CP2000 notice requesting clarification. Taxpayers must respond with supporting documentation, such as purchase records, improvement receipts, or appraisals, to substantiate their reported basis.

If further scrutiny is required, the IRS may initiate a formal audit, conducted via mail, in an IRS office, or at the taxpayer’s home or business. If the IRS disputes the claimed basis, they may adjust the capital gain calculation, leading to additional tax liability, interest, and potential penalties. Taxpayers who disagree with the findings can appeal through the Office of Appeals or petition the U.S. Tax Court.

Consequences of Incorrect Basis

Misreporting cost basis can lead to financial and legal consequences. If a taxpayer overstates their basis, they may underreport capital gains, resulting in an underpayment of taxes. The IRS can impose accuracy-related penalties, typically 20% of the underpaid tax if the discrepancy exceeds the greater of $5,000 or 10% of the correct tax liability. If the misstatement is intentional, civil fraud penalties can apply, increasing the penalty to 75% of the underpayment.

Incorrect basis reporting can also extend IRS scrutiny. The standard statute of limitations for tax audits is three years, but if the IRS identifies a substantial omission of income—defined as more than 25% of the correct taxable amount—the audit window extends to six years. In cases of fraud, there is no statute of limitations, meaning the IRS can challenge the basis indefinitely. Taxpayers who fail to provide adequate documentation may struggle to defend their position in appeals or court proceedings, increasing their potential tax liability.