Understanding the cost basis and how to calculate it is important for rental real estate investors. That’s because your cost basis on a property determines how much taxable profit you make when selling a profit, which can directly affect your tax liability. Calculating the cost basis starts with figuring out the cost to acquire your property and may be adjusted due to improvements and depreciation. A financial advisor can help you determine your cost basis on a rental real estate investment.
Understanding the Basics of Cost Basis
The cost basis of an asset such as a rental real estate property refers to the original value of an asset as calculated for tax purposes. For many assets, such as stocks, the cost basis simply is what it cost to buy the asset. When applied to rental restate the cost basis can be different from the acquisition cost because it may be adjusted for factors such as improvements or depreciation.
It’s important to know the cost basis of a rental property because, when you sell it, the cost basis is used to calculate capital gains tax. The capital gains tax is a special tax on profits made from selling assets.
Calculating the taxable gain on an asset sale is done by subtracting the cost basis from the sale price of the asset. With this in mind, understanding how to calculate your cost basis is central to understanding your potential tax liability.
Calculating Cost Basis
Figuring your cost basis can be complicated but in many cases is straightforward. For instance, if an investor purchases a rental property for $300,000, in the simplest case the purchase price would be the cost basis. If the investor sells the property for $350,000, they would have a $50,000 gain to which capital gains taxes would normally apply.
That is a very simple example. In many cases, the cost basis can be adjusted upward or downward based on a few different factors.
Increases to Cost Basis
One way the cost basis of your property can increase is by doing improvements and additions. For example, if the above investor spends $20,000 on a new roof, this cost increases the cost basis to $320,000. Now if the investor sells for $350,000, the taxable gain will only be $30,000.
Not all rental expenses increase cost basis. For example, spending money to have a plumber unclog a stopped-up drain wouldn’t increase the cost basis. A new roof isn’t a similarly routine repair or maintenance, but a significant improvement that adds to the property’s value. Renovating the kitchen is another example of an improvement that could adjust the cost basis upward.
Decreases to Cost Basis
The cost basis can also decrease. Depreciation is a common way for cost basis to decrease. An investor who owns rental property can deduct a certain amount for depreciation each year on their taxes. When the investor deducts depreciation, it increases the cost basis by the same amount.
For example, an investor who takes $5,000 a year for depreciation over ten years will have taken a total of $50,000. This amount would be subtracted from the cost basis. Using the same initial cost basis as above, after accounting for depreciation the adjusted cost basis would be $300,000 (purchase price) + $20,000 (roof) – $50,000 (depreciation) = $280,000.
Cost Basis and Capital Gains
When selling the rental property, the investor will subtract the adjusted cost basis from the sale price to determine the capital gain. If the property sells for $350,000, the capital gain would be $350,000 (sale price) – $280,000 (adjusted cost basis) = $70,000. This $70,000 is the capital gain for tax purposes.
Good recordkeeping helps make for an accurate and relatively easy cost-basis calculation. It’s useful for a rental real estate investor to keep track of all the documents and receipts related to the property purchase, improvements and depreciation deductions.
The Bottom Line
Understanding and accurately calculating your cost basis is a vital part of real estate investing. It helps an investor understand the potential profit from a sale as well as tax liabilities. When selling property, subtract the cost basis from the sale price to determine the amount of capital gains on which you will owe taxes. The cost basis starts with the purchase price of a property and is adjusted for improvements and depreciation over time.
Tips for Tax Planning
- Tax laws are complex and changing, so it’s a good idea to consult with a financial advisor when dealing with these issues. Finding a financial advisor doesn’t need to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s free online Capital Gains Tax Calculator will help you see how much tax you’ll owe when selling rental real estate or other investment assets.
Photo credit: ©iStock.com/Perawit Boonchu, ©iStock.com/Wasan Tita, ©iStock.com/guvendemir