When evaluating the investment potential of a property, there are many important factors to consider. One that is sometimes overlooked is the adjusted cost basis. This calculation will help you determine the property’s value and the potential profit from its sale.
The following guide provides a look at the difference between cost basis and adjusted basis and provides a simple overview of the calculation method. Once you understand these details, you’ll be better equipped to choose investment properties that are most likely to meet your needs.
What is Cost Basis?
The term cost basis refers to the total purchase price of a property combined with the realtor commissions and other closing costs. When a property is sold, the cost basis (sometimes just called “basis”) is used to calculate your taxable gain or loss.
If the sale price is above the basis, it creates a gain, and when it’s below, you have a loss. Generally, a high-cost basis results in a smaller gain or a greater loss.
The use of financing on a property’s purchase does not affect its cost basis. However, your closing costs adjust the basis upwards. You can find your closing expenses listed on your closing statement. There may also be some additional costs that are not listed, so check with your tax professional to ensure you’re using the correct amount.
Cost Basis vs. Adjusted Basis
Cost basis is calculated based on the purchase transaction. However, as you hold the property, the basis is adjusted. The formula for adjusted cost basis is the original cost basis increased by capital expenditures and reduced by your depreciation deductions.
While routine repairs and maintenance do not result in adjustments to the basis, capital improvements, such as adding a new room, adjust the basis upward by the cost of the improvement. In addition, you are permitted to adjust your basis downward based on the building’s tax depreciation and by the amount of any property casualty or theft losses.
To accurately determine a property’s value, it’s important to factor in all of the additional costs and depreciation you incur over the lifetime of your property ownership. Following is a closer look at how the calculation works.
How to Calculate Adjusted Basis
To calculate a property’s adjusted basis, follow these three simple steps:
Begin With Your Original Investment in the Property
Add the Cost of Major Improvements
Subtract Allowable Depreciation and Casualty and Theft Losses
Being able to do this accurately requires you to understand which expense to include and whether they increase or decrease your basis.
Costs That Increase Your Basis
Acquisition costs – surveys, transfer fees, title fees, etc.
Cost of additions or capital improvements made to the property
Utility installation expenses
Property-related legal fees
Costs to restore damage from fire, theft, flooding, or other casualties
Post-2005 home energy improvement tax credits
Costs That Decrease Your Basis
Depreciation on business or rental properties
Insurance reimbursements following a theft or casualty loss
Casualty loss deductible that wasn’t covered by insurance
Income received for granting an easement
Gain on sales of a home sold before May 7, 1997
Assume you purchased a home for $600,000 and had closing costs of $13,500. While you owned the home, you put $200,000 into improvements, which increases your basis.
In this case, your adjusted basis is:
$600,000 + $13,500 + $200,000 = $813,500
If you sold the property for $1 MM and had $50,000 in closing costs, your sales proceeds would be:
$1,000,000 - $50,000 = $950,000
To calculate your capital gain, subtract your adjusted basis from your sales proceeds:
$950,000 - $813,500 = $136,500
Capital Gains Deferral
Once you’ve calculated your potential capital gains and considered the taxes you could owe on the sale of the property, you may wish to consider a 1031 exchange. This allows you to defer paying capital gains taxes on your property sale by using the proceeds to purchase a like kind replacement property. Under IRS guidelines, this could be a physical property or a Delaware Statutory Trust (DST). Many investors appreciate the passive nature of a DST investment and find it to be a suitable replacement property.
Obtaining Additional Basis During a 1031 Exchange
If an investor acquires replacement properties with greater debt, they will gain additional basis that may allow them to increase their after-tax income.
For example, if an investor has sold a property with no loan on it for $1 million in net proceeds and decides to invest in a portfolio of DSTs having an average loan to value of 50%, they will end up acquiring DST property interests valued at $2 million ($1 million of equity + $1 million of debt).
The additional $1 million of property interests acquired will increase the total basis held by the investor and provide higher depreciation deductions that can shelter/reduce taxable income and generate higher after-tax cash flow.
There are additional trade-offs to consider when using additional debt that should be discussed with a knowledgeable tax advisor.
To learn more about 1031 exchanges and DST investments, please contact our team. We’ll provide you with a consultation and can refer you to a tax professional who can assist with your adjusted cost basis calculations.