What Is House Cost Basis and How Is It Calculated?

A home’s cost basis is its value for tax purposes and is the starting point for determining the capital gain or loss when the property is sold. A higher basis can reduce the taxable profit from a sale, which lowers your tax liability. The goal is to maximize this basis within the rules set by the Internal Revenue Service (IRS) to minimize potential tax.

The calculation begins with an initial basis that is adjusted for various events over the life of your ownership. Keeping detailed records is the most effective way to substantiate your final adjusted basis.

Establishing Your Initial Basis

The method of acquiring a property dictates how its initial basis is determined. The rules differ for homes that are purchased, inherited, or received as a gift.

Purchased Home

When you buy a home, the initial basis is the contract purchase price. This includes the total amount you agree to pay through cash, a mortgage, or by assuming an existing mortgage. Certain settlement fees and closing costs paid by the buyer are also added to this figure.

Includable costs are items necessary to complete the purchase, such as:

• Abstract fees
• Legal fees for the transaction
• Recording fees
• Land surveys
• Transfer taxes

Costs associated with obtaining a loan, such as mortgage application fees, credit report fees, and points paid to the lender, are not added to the basis. Other excluded expenses include fire insurance premiums, rent for occupying the home before closing, and ongoing homeownership expenses.

Inherited Home

For an inherited home, the basis is determined by a “stepped-up basis.” The heir’s initial basis is the Fair Market Value (FMV) of the property on the date of the original owner’s death. This rule means any appreciation in the home’s value during the decedent’s ownership is erased for capital gains tax purposes.

The FMV is established through a professional appraisal conducted near the time of death, and this value, documented in the appraisal report, becomes the new starting point for the inheritor. For example, if a parent bought a home for $50,000 and it was worth $400,000 upon their death, the inheriting child’s basis is $400,000.

Gifted Home

When a home is received as a gift, the recipient takes on the donor’s adjusted basis at the time of the transfer. This is known as a “carryover basis.” For instance, if your parent gifts you a home with an adjusted basis of $150,000, your initial basis is also $150,000. If the donor paid federal gift tax on the transfer, a portion of that tax may be added to the recipient’s basis.

A special rule applies if the home’s FMV is less than the donor’s adjusted basis at the time of the gift. In this case, the basis for calculating a future gain is the donor’s carryover basis. The basis for calculating a future loss, however, is the lower FMV at the time of the gift.

Making Adjustments to Your Basis

During homeownership, various events can increase or decrease your initial basis. The resulting figure is the adjusted basis, which is the value used to calculate your gain or loss when you sell the property.

Increases to Basis (Capital Improvements)

Homeowners can increase their basis by making capital improvements. A capital improvement is work that adds value to your home, prolongs its useful life, or adapts it to new uses. These are distinct from repairs, which maintain the home’s condition and are not added to the basis.

Examples of capital improvements include:

• Adding a new room, finishing a basement, or building a deck
• Installing a new roof, central air conditioning unit, or furnace
• Paving a driveway or installing a fence
• Completing significant landscaping projects

In contrast, repairs are routine maintenance tasks like repainting a room, fixing a leak, or replacing a broken window pane. While necessary for upkeep, these expenses do not increase your basis.

Decreases to Basis

Certain events require a homeowner to reduce their property’s basis. Your basis must be decreased for:

• Receiving a tax credit for energy-efficient home improvements, such as for installing solar panels. The basis is reduced by the credit amount.
• Receiving insurance or other reimbursements for casualty or theft losses.
• Claiming a casualty loss deduction on your tax return for damage to your home.
• Claiming depreciation deductions for using a portion of your home for business or as a rental property.

Calculating Your Final Adjusted Basis and Capital Gain

After tracking all adjustments, you can determine your final adjusted basis and capital gain. First, calculate the final adjusted basis using this formula: Initial Basis + Total Increases – Total Decreases = Final Adjusted Basis.

Next, calculate your capital gain or loss with this formula: Selling Price – Selling Expenses – Final Adjusted Basis = Capital Gain or Loss. A positive result is a capital gain, while a negative result is a capital loss, which is not deductible for a personal residence.

Selling expenses are costs associated with the sale, such as:

• Real estate commissions
• Advertising fees
• Legal fees
• Title costs

Applying the Home Sale Exclusion

After calculating a capital gain on the sale of your home, a tax provision may allow you to exclude a portion of the gain from your taxable income. This exclusion can reduce or eliminate the tax owed from selling your primary residence.

Ownership and Use Tests

To qualify for the full exclusion, you must meet two tests. The ownership test requires you to have owned the home for at least two of the five years leading up to the sale date. The use test requires you to have lived in the home as your principal residence for at least two of the five years before the sale.

These two-year periods do not need to be continuous. For married couples filing a joint return, at least one spouse must meet the ownership test, but both must meet the use test to qualify for the maximum exclusion. The five-year period for both tests ends on the date you close the sale.

Exclusion Amounts

The maximum amount of gain you can exclude is $250,000 for single filers or those who are married and file separately. For married couples who file a joint tax return and meet the eligibility requirements, the maximum exclusion amount is $500,000.

Limitations and Special Cases

A homeowner can only claim the exclusion once every two years. If you sell another primary residence within two years of using the exclusion, you cannot use it again.

The IRS allows for a partial or reduced exclusion if you fail to meet the two-year tests because of a change in health, a change in your place of employment, or other unforeseen circumstances. The amount of the partial exclusion is prorated based on the portion of the two-year period you met the requirements.