We take a look at rental property cost basis and the role it plays in capital gains tax and depreciation recapture.
Rental properties are subject to various forms of taxation, from rental income tax, state property taxes, and of course capital gains tax.
Understanding these various forms of taxation and the tax strategies you can employ to reduce your tax bill is essential if you want to maximize your portfolio profitability and achieve your financial goals.
The adjusted basis in real estate is an important metric investors use to when calculating the tax burden when selling a rental. Its primary use is to calculate capital gains and losses during tax season to determine how much you’ll owe for that year.
In this article, we take a closer look at what adjusted cost basis is, how you can calculate the adjusted basis in real estate, and the role that rental property cost basis plays in capital gains tax and depreciation recapture.
The cost basis of a rental property is essentially the original value of the property, plus any additional costs incurred in the process of purchasing such as agent fees. In other words, it is the total amount of money spent acquiring the property.
It serves as the foundation for determining the property's capital gains or losses when it is eventually sold.
To calculate the capital gain or loss when selling the property, you subtract the cost basis from the sale price. If the sale price is higher than the cost basis, you have a capital gain; if it's lower, you have a capital loss.
As mentioned above, the basis (also known as the cost basis) in real estate is the total cost of acquiring an investment property. This figure encompasses the purchase price and related fees.
The adjusted cost basis is a modification of this initial basis – the property's purchase price – taking into account expenses that effect the value of the property. For example, the amount of depreciation claimed reduces the property's value. But you can also add to the property's value if you invest in capital improvements.
This adjustment is used to more accurately reflect the gains or losses of an investment property when it's sold.
The adjusted basis of a rental property does not factor in rental income or landlord-related expenses. Rental income is treated as ordinary income and expenses are claimed against this income in the year they're accrued.
In summary, real estate adjusted cost basis, is a metric that is used exclusively during the sale of the property to enable the IRS to accurately gauge the taxable capital gains of the property taking into account both depreciation and additional investment into the property.
To calculate the adjusted basis you will need to start with the original purchase price of the property, irrespective of whether an investment property loan, DSCR loan, or any other mortgage type was utilized. This initial figure is referred to as the basis.
Over time your rental property cost basis can either increase or decrease in value.
An increase in the basis works to your advantage as this essentially reduces the amount of taxable gain when you sell. On the other hand, a decrease in the basis leads to an increase in capital gains and the tax liability upon sale.
To calculate the adjusted basis, you can modify the original basis by adding or subtracting various costs, including:
Other expenses that can impact the basis include factors like impact, zoning, realtor fees, closing costs, and legal fees.
As a general rule, deductions for expenses incurred in a particular year are not factored into the adjusted basis. For example, deductible expenses such as repairs and maintenance are excluded from the adjusted basis because they are deducted in the tax year in which they are filed.
Calculating the adjusted basis for a rental property involves starting with the purchase price and adding the cost of improvements that enhance the property's value.
You then deduct expenses like depreciation and losses. The resulting figure represents your adjusted basis for the rental property, ultimately determining whether a capital gain or loss has occurred upon the property's sale.
Adjusted Basis = Original Basis + Capital Improvements – Depreciation – Casualty Losses
Suppose you chose to invest in San Francisco real estate and acquired a single-family home for $300,000 with a mortgage of $240,000, which implies a $60,000 cash payment.
To calculate the adjusted basis, focus solely on the property's purchase price, disregarding the loan. Adding associated fees, such as taxes, closing costs, and realtor commissions, which amount to $18,000 in this instance, brings your initial basis to $318,000 – reflecting the total expenditure for the property.
Over the five years you own the property, you invest $25,000 in improvements. Additionally, your property suffered storm damage, incurring $7,000 in repair costs (casualty losses), and you claimed $9,000 a year in depreciation, totaling $45,000.
Plugging these numbers into the cost basis formula above you get:
Therefore, your adjusted basis is $291,000.
To calculate the capital gain upon selling the property you then need to deduct this adjusted basis from the sale price of the property.
For example, you sell the property after this five-year period for $400,000.
Subtract real estate commissions / closing costs of $25,000
Adjusted sale price=$375,000
Subtract adjusted basis of $291,000
Taxable capital gain=$84,000
At this point, you will then need to split out the taxable capital gains from the depreciation amount as these are taxed at slightly different rates, with capital gains taxed at a maximum of 20% and the depreciation recapture tax rate at a maximum of 25%.
Real estate investing comes with a number of tax benefits. However, it can quickly become complex with depreciation, cost segregation, safe harbor, tax deductions, capital gains, 1031 exchanges and more.
The adjusted basis in real estate is an essential metric for investors to come to terms with when thinking about selling your rental property if you want to avoid being surprised by your tax bill. It is used to more accurately determine the taxable capital gains factoring in both depreciation and additional investments made into the property.
To truly come to grips with your rental property finances it is important not only be armed with the knowledge around nuanced tax scenarios like adjusted basis but to have the tools you need to accurately track your rental property finances, including purchase price, depreciation, capital improvements, closing costs, legal fees and more. Not only will this enable you to file an accurate tax return maximizing your deductions and increasing your ROI, but it will also be essential when it comes to actually calculating your adjusted cost basis.
This is where Landlord Studio comes into play, offering a suite of powerful accounting and reporting tools. Landlord Studio's intuitive software will help you streamline your financial management, and effortlessly track expenses so that you can make informed and profitable investment decisions.
Many of the costs associated with purchasing and upgrading your home can be deducted from the cost basis when you sell it. These include most fees and closing costs and most home improvements that enhance its value. It does not include routine repairs and maintenance costs.
The IRS defines the cost basis of the stock shares or the bonds as their purchase price plus any costs related to the transaction such as broker fees. When you sell shares of mutual funds, you can in some cases use an average cost basis.
Increases to your cost basis include improvements such as a new roof on a house and the cost of local tax assessments for water connections or roads.
Examples of decreases to cost basis include insurance deductions, subsidies for energy enhancements, and depreciation.
The adjusted cost base is usually the cost of a property plus any expenses to acquire it, such as commissions and legal fees. Special rules can sometimes apply that will allow you to consider the cost of the capital property to be an amount other than its actual cost.
The adjusted basis of an asset is generally its purchase price plus capital improvements and costs of sale, less any tax deductions you previously took for the property. The higher your adjusted basis is, the less you'll pay in the way of capital gains tax when you sell and realize a profit
In real estate transactions, the IRS can verify the cost basis by looking at the closing statement of when the property was purchased, or any other legal documents associated with the property, such as tax statements.
You'll report the adjusted basis on a rental property on IRS Form 4797 or Schedule D of Form 1040 in the year you sell the property. Schedule D is for gains and losses on personal property, while Form 4797 is for property used to conduct business.
If your property is both for personal and business use, you'll need both forms.
Your adjusted basis for figuring a loss is the FMV of the property at the time the donor made the gift, increased or decreased by any required adjustments to basis while you held the property
If the goal is to pay less in taxes, it's better to have a higher adjusted basis, which means you have lower capital gains when you sell the property. On the other hand, if your main concern is profits, you might want a lower adjusted basis even though you'll pay more in taxes.