How to Calculate Cost Basis for Rental Property

Cost basis is the total investment in a property for tax purposes. It serves two main functions for rental property owners. First, the cost basis is the starting point for calculating the annual depreciation deduction, which allows an investor to recover the cost of the property over time. Second, it is used to determine the amount of capital gain or loss realized when the property is eventually sold.

Determining Your Initial Cost Basis

A rental property’s initial cost basis begins with its purchase price, which is the amount you paid in cash or through a loan. To this amount, you add numerous costs associated with the acquisition that were necessary to complete the purchase.

A settlement statement, like the Closing Disclosure form, lists many of these costs. Includable expenses are items like abstract fees, charges for installing utility services, legal fees, recording fees, surveys, transfer taxes, and title insurance.

Certain other settlement costs are not included in the property’s basis. These are expenses that are deducted in the year they are paid, such as prorated real estate taxes or casualty insurance premiums. Fees for getting a loan, such as loan origination fees or points paid to secure a mortgage, are not added to the basis. For example, if you bought a rental for $300,000 and paid $2,000 in recording fees and $1,500 for title insurance, your initial cost basis would be $303,500.

The total initial cost basis must be allocated between the land and the building because land cannot be depreciated. This allocation is often done using the property tax assessor’s valuation of the land and building.

Calculating the Adjusted Cost Basis

A property’s initial cost basis is not static; it changes over the ownership period and becomes the adjusted cost basis. Adjustments include increases that add to your basis and decreases that reduce it.

Increases to the basis result from capital improvements. A capital improvement is an expenditure that adds to the property’s value, prolongs its useful life, or adapts it to new uses. Examples include adding a new room, installing a new HVAC system, or replacing the entire roof.

Repairs, in contrast, are things like fixing a leaky faucet, repainting a room, or replacing a broken window pane. While these are deductible business expenses for a landlord, they do not increase the adjusted cost basis. Improvements are capitalized and recovered through depreciation over time, while repairs are expensed in the year they occur.

The most consistent decrease to basis comes from the annual depreciation deduction. Each year, you deduct a portion of the building’s cost, and that deduction reduces your adjusted basis in the property.

Other events can also lead to a decrease in basis. If you receive an insurance payout for a casualty loss, the amount of the reimbursement reduces your basis. Claiming certain tax credits related to the property can also result in a basis reduction.

Basis for Property Converted to Rental Use

When converting a personal residence into a rental, a special rule determines the basis for depreciation. This rule is designed to prevent taxpayers from deducting a personal loss in their home’s value that occurred while it was a personal residence. It is important to get an appraisal or use comparable sales data to establish the FMV on the conversion date.

According to IRS Publication 527, the basis for depreciation is the lesser of two amounts: the property’s adjusted cost basis or its fair market value (FMV) on the date of conversion. The adjusted cost basis is what you originally paid for the home plus the cost of any improvements you made while living there. The FMV is the price the property would sell for on the open market at the time you place it in service as a rental.

For example, imagine you bought your home for $250,000 and added a deck for $20,000, making your adjusted basis $270,000. If, on the day you convert it to a rental, the property’s FMV is only $240,000, you must use the lower $240,000 figure as your basis for calculating depreciation.

Basis for Inherited or Gifted Property

Acquiring a rental property through inheritance or as a gift involves different rules for determining its basis compared to a direct purchase. For inherited property, the basis is “stepped-up” to the fair market value (FMV) of the asset on the date of the original owner’s death. This means that any appreciation in the property’s value during the decedent’s lifetime is not subject to capital gains tax.

For instance, if an individual bought a property for $100,000 and it was worth $500,000 on the day they died, the heir who inherits it receives the property with a new basis of $500,000. This stepped-up basis becomes the starting point for the heir’s own holding period, from which they will calculate future depreciation and any gain or loss upon a subsequent sale. This rule can provide a tax benefit to beneficiaries.

The rule for gifted property is different. When you receive property as a gift, you take on the donor’s adjusted basis at the time of the gift, known as a “carryover basis.” For example, if the donor’s adjusted basis was $150,000, your basis for calculating a future gain is also $150,000, regardless of the property’s FMV when you received it.

If the property’s FMV at the time of the gift is less than the donor’s adjusted basis, a dual-basis rule applies. To determine a future gain, you use the donor’s adjusted basis. To determine a future loss, you use the lower FMV.

Using Cost Basis to Calculate Gain or Loss on Sale

Tracking your adjusted cost basis is necessary for calculating your total capital gain or loss when you sell the property. To calculate your capital gain or loss, start with the property’s gross sale price. Subtract selling expenses, such as real estate commissions and legal fees, to find the net sale price. Your total gain or loss is the net sale price minus your adjusted cost basis.

Consider a property with a final adjusted cost basis of $220,000. If you sell it for $400,000 and incur $25,000 in selling expenses, your net sale price is $375,000. Subtracting the $220,000 adjusted basis from the $375,000 net sale price results in a total gain of $155,000. This gain is what will be subject to taxation.

A portion of this gain is subject to depreciation recapture. The total depreciation you deducted over the years, which lowered your adjusted basis, must be “recaptured” upon sale. This recaptured amount is taxed at a different rate than the remaining long-term capital gain. This is reported on IRS Form 4797, Sales of Business Property.