By: Paul Novak, CPA, ABV
Key Takeaways:
- Cost basis is the original value of an asset, including purchase price and acquisition expenses, used to calculate taxable gain or loss when sold.
- Properly calculating the cost basis can help minimize capital gains taxes as well as the amount of depreciation that is being recaptured that is taxed as ordinary income, up to a maximum rate of 25%.
- Adjustments: The cost basis can change with capital improvements, casualty losses, and depreciation, all of which impact tax liabilities when the property is sold.
Accurate Cost Basis Calculation Can Minimize Taxes
Understanding the concept of “cost basis” is essential to any real estate investor, as it can have a significant impact on their tax liabilities and overall investment strategy.
Cost basis is a fundamental concept when it comes to real estate investments. It refers to the original value of an asset – in this case, real property – and it plays a crucial role in determining the taxable gain or loss when the property is sold.
Cost basis represents the initial investment in a property and includes various components. It typically includes the purchase price of the property, along with any additional expenses incurred during the acquisition, such as legal fees, closing costs and real estate agent commissions. Additionally, improvements made to the property over time, such as renovations or additions, can also be added to the cost basis. It is important to maintain accurate records of all these expenses to calculate the cost basis correctly.
For example, let’s say you purchased a residential property for $200,000. During the acquisition process, you paid $10,000 in closing costs and $5,000 in legal fees. Subsequently, you invested an additional $20,000 in renovations. In this case, your total cost basis would be $235,000 ($200,000 + $10,000 + $5,000 + $20,000).
Adjustments to Cost Basis
While the initial cost basis is determined at the time of purchase, it may be subject to adjustments during the holding period of the property. Certain events or expenses can increase or decrease the cost basis, thus affecting the taxable gain or loss upon sale.
Some common adjustments to the cost basis include capital improvements, casualty losses and depreciation.
Capital improvements refer to significant upgrades or additions that enhance the property’s value. These expenses can be added to the cost basis, thereby reducing the taxable gain.
For instance, let’s consider the earlier example of a property with a cost basis of $235,000. Suppose you later invested an additional $15,000 in capital improvements. In this case, your adjusted cost basis would be $250,000 ($235,000 + $15,000)
Casualty losses, such as damages caused by natural disasters or accidents, can potentially result in a tax deduction that will reduce the basis of the property. The basis should also be reduced by for any insurance proceeds received even if no deduction is claimed for the casualty loss.
Depreciation expenses, which account for the wear and tear of the property over time, will also reduce the cost basis.
Impact of Cost Basis on Taxes
Understanding the impact of cost basis on taxes is important for real estate investors. By accurately calculating the cost basis and considering any adjustments, investors can minimize their tax liabilities and maximize their after-tax returns.
If the property is sold for more than the cost basis, it results in a gain, which is subject to taxation as either a capital gain that is taxed at a maximum rate of 20% or as ordinary income taxed up to a maximum rate of 25% for the depreciation that is being recaptured on rental real estate properties. On the other hand, if the property is sold for less than the cost basis, it leads to a loss, which may be treated as a capital loss or as an ordinary loss depending on whether or not the property is rental real estate property or not.
It is worth mentioning that IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
Calculating the cost basis correctly will help the real estate investors in evaluating the profitability of an investment and assessing the return on investment (ROI) over time.
If you would like to discuss calculating the cost basis of an investment property you own, contact your KRD advisor.
