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Posted by Tiffany Gaskin

What is Cost Basis in Real Estate & How to Properly Calculate it

What is Cost Basis in Real Estate & How to Properly Calculate it

The cost basis in real estate can significantly impact your tax liability. If you're buying a property, understanding the cost basis in advance can help you prepare for the possible tax consequences of the sale.

Let's see how the cost basis of real estate can affect your tax bills.

What is the cost basis in real estate?

The cost basis of real estate can be considered the total cost of buying and owning a property. Knowing the price of your home is important from a tax perspective because when you sell your home, you will have to pay capital gains tax on any amount that is more than what you originally paid for the property, subject to certain limitations.

Why is cost basis important in real estate?

The cost basis in real estate basically serves as a reference for the owner. If they sell your estate for more than the cost basis, they have to pay tax on the difference.

The cost basis can affect your tax obligations as a homeowner or anyone selling a home. The IRS will use the cost basis to determine the seller's profit on the sale of a property. You could have a large tax bill if you sold with a large profit.

What is included in a Property's Cost Basis?

The cost basis is important when the property is sold. At this point, it is used to determine the capital gains tax payable. But it is important to track the property's cost basis throughout your ownership.

Here is what is included in the cost basis price of a property:

  • Price paid for the property: The purchase price is a starting point.

  • Recording Fee: The recording fee you paid as part of the closing costs must be included.

  • Other Legal Fees: Necessary legal fees may be included in the closing process.

  • Seller's debts paid by the buyer: In some cases, you will pay the seller's debts for purchasing a property. These costs can be included in the cost basis. Speak to a tax professional for more details.

Factors Affecting the Cost Basis

In some cases, the cost basis is easy to calculate. But in special situations, the calculations change. Here's how the cost basis can change depending on how the property is acquired.

Cost basis for inherited estates

If you inherit an estate, the cost basis usually depends on when the original owner died. The cost basis is generally the fair market value when ownership passes to you from the original owner.

The cost basis for Gifted Properties

If you receive property as a gift, the donor will not receive fair market value as compensation.

The recipient can use the donor's adjusted basis when selling the property for profit. If the recipient sells the property at a loss, the basis may be the donor's adjusted basis or the fair market value when the gift changes hands.

Cost basis for investment properties

Investors use their cost basis to depreciate property and reduce taxable income for the year. As with other homeowners, the original cost basis is the amount paid to purchase the property, plus taxes and the cost of improvements made. But with depreciation, the investor can lower their cost basis over time.

At some point, investors can sell the property and get a refund. Essentially, this means a higher tax. But that could be avoided by doing a 1031 exchange. Again, talk to a tax advisor.

Adjusted Basis in Real Estate

An adjusted basis in real estate refers to a cost basis that changes over time. Depending on the situation of your property, there are many reasons for an adjusted basis.

Here are some elements that can increase your cost basis:

  • Home Improvements: Home improvements that increase the home's value will be added to the cost basis.

  • Property Legal Fees: Legal fees required to keep the property in good working order will increase the cost basis.

Here are some factors that can reduce your tax basis:

  • Depreciation: Investors use depreciation to reduce the year's taxable income and income tax. This results in a lower cost basis.

  • Receive insurance benefits in the event of a claim: Loss or theft benefits put money in your pocket and reduce cost basis.

  • Tax credits on certain home energy upgrades: The right home supply upgrade comes with a tax credit, which is factored into your cost basis.

These are just a few scenarios to give you an idea of what a cost basis is. If you have questions about a particular situation, it is best to consult a tax specialist. They can help map out the most simplified cost basis for tax purposes.

How do I Calculate the Cost Basis for Real Estate?

The cost basis of the property has critical tax implications. Here is an example of how the cost basis is calculated in the real world.

Let's say you buy a property as your primary residence for a purchase price of $250,000. Over the years, you invested an additional $50,000 in home improvements, such as a new bathroom and kitchen. These upgrades increased your adjusted basis to $300,000.

You install $5,000 worth of solar panels on the roof at some point. But a $5,000 tax credit made this transaction a wash in terms of cost basis. With these costs, your current cost basis is $300,000. After 10 years in the home, you decide to move on. The house is for sale for $450,000.

When you sell, you make a profit of $150,000. You may be subject to capital gains tax on your profits at tax time. However, as the owner who has lived in the home for two of the past five years, you can exclude up to $250,000 from this income. This can go up to $500,000 if you file a joint return.

For the cost basis of your property, it's a good idea to update the numbers regularly. When an expense affects your cost, document it clearly for future reference. The IRS may need to see specific documentation for any transactions that result in an adjusted cost basis when it comes time to calculate capital gains tax.

The Bottom Line

The cost basis in real estate is an important point at tax time. Although cost-basis impact comes into play when selling a home, it is essential to understand where the cost basis lies before selling. Otherwise, you could be in trouble for a tax bill you can't pay.



Tiffany Gaskin
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