What Is Cost Basis and Why Is It So Important for Your Taxes?
October 3, 2022
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Do You Know Why Cost Basis Is So Important For Your Taxes?
When you sell a rental property, your capital gain or loss is determined by subtracting your cost basis from your selling price.
For this reason, understanding how to calculate cost basis and reporting it is critical when evaluating existing or future investments.
What is Cost Basis?
When you first acquire a property, the cost basis is equal to the purchase price you paid for that property. However, over time, your cost basis on that property can and will change. This is critical to understand and where most people trip up: cost basis doesn’t necessarily equal purchase price – that is merely the starting point.
Primarily, two things can impact your cost basis:
Depreciation lowers your cost basis resulting in higher capital gains and a potentially higher tax bill. Improvements increase your cost basis, resulting in lower capital gains and a potentially lower tax bill. It’s really that simple, but let’s dive a bit deeper into some examples of how each of these changes your cost basis.
Depreciation allows landlords to reduce the value of their property over time in the eyes of the IRS. Depreciation is the process of deducting the cost of assets over a period of time to account for everyday wear and tear. For instance, if you buy a building, it will naturally decay, which means it won’t be as valuable as it was when you first bought it.
A key figure to know here is 27.5. This is the number of years the IRS sets as the useful life for residential rental properties. So, this is the longest amount of time you can collect depreciation for.
If you want a more detailed answer to the question, “How is rental property depreciation calculated?” we recommend this article: How to Calculate Depreciation.
For many investors and many properties, the purchase price is only the first in a series of capital injections they will make into a particular property. As you continue to pour more money into a property, the amount of gain you will have in a potential sale should change too.
Let’s say, for example, that you purchase a property for $100,000. If you sold it the next day for $150,000, it’s clear that your gain is $50,000, and that is the amount on which the IRS would look to tax you.
But let’s say that after purchase, you spent $50,000 on a new roof, new kitchens, bathrooms, appliances, etc. If you sold the property for $150,000 the next day in this scenario, it would feel awfully unfair if the IRS attempted to collect taxes on a $50,000 gain. You’d actually lose money in that scenario!
Instead, the IRS recognizes the $50,000 as an improvement that you made to the property and increases your cost basis by that amount. Now, when calculating your taxes, your gain is $0. If you instead sold the property for $175,000, your gain would be $25,000.
But not all dollars spent on your property are considered improvements. If you replace a furnace filter for $20, you would file that money spent under Maintenance and Repairs for tax purposes, it would be immediately and fully deductible from your income, and it would not impact your cost basis in any way.
Generally, only substantial changes to the property are considered improvements in the eyes of the IRS – think renovations or adding a luxury hot tub in your backyard. Your CPA should be able to guide you when determining whether something is an improvement or not, but if you’d like additional assistance, check out our article [What is the Difference Between Repairs and Improvements?].
Calculating Your Cost Basis and Why it’s Important
Every time you improve your property and every year as you file your taxes and record additional depreciation, your cost basis changes. The new figure that takes these changes into account is known as the adjusted cost basis. If you know your adjusted cost basis, you’ll have a far better understanding of your potential tax bill. The calculation itself is quite simple; however, it relies on an accurate record of money invested and taxes paid. If you have that, you’re well on your way.
To calculate the adjusted cost basis, start with your original purchase price on a property, add the total cost of all improvements you’ve made to it and subtract the total of all depreciation taken.
To better understand exactly how this works, here is an example:
Let’s say Maria buys a home for $350,000 and sells it 20 years later for $550,000. And in the 20 years she owned the property, she made improvements that cost $50,000 (e.g., replaced a leaky roof, oversaw kitchen renovations, etc.). So, recalling the formula from earlier, the adjusted cost basis is now $400,000.
But we cannot forget about depreciation. For this example, we will utilize straight-line depreciation, the most common kind of depreciation for capital assets like homes. The formula for annual depreciation expense means you take the $350,000 cost basis and divide it by the standard useful life of residential rental properties set forth by the IRS of 27.5 years. Thus, the annual depreciation amount is $12,727.27.
Why is all of this so important? Your adjusted cost basis and depreciation impact your taxable income. Once you add up the total depreciation amount, you can then subtract the depreciation from your pre-tax income to determine your taxable income. And your taxable income will determine how much you actually owe the IRS. So, this is quite a crucial number.
One final unfortunate caveat: Recapture is something you need to be aware of. Recapture is the method by which the IRS recoups money they don’t initially see because of depreciation. Simply put, you cannot claim depreciation for a home and then sell that same home without “repaying the IRS” through income tax on the profit you made.
This may seem completely unfair at first. What is the advantage of depreciation deductions if the IRS takes all of it back later? It’s important to remember, though, that property typically appreciates over time. Depreciation was always just a short-term deferral of your taxes, but that doesn’t make it any less beneficial. Also, it’s worth mentioning that you’ll get taxed for it whether or not you take deductions, so it’s always best for your business to take them.
Check out this article on recapture to learn more about recapture: Landlords and Taxes: Understanding Recapture.
Now, before we wrap up this piece, let’s try to tie everything we’ve learned together. One last example should help with this.
Let’s use the table below to work through this example:
|Depreciation deductions claimed in 5 years||$5,000 per year|
|Sale amount in year 6||$990,000|
|Depreciation recapture tax rate||20%|
|Capital gain tax rate||15%|
So, first off, the adjusted cost basis is (900,000 + 100,000) – (5,000 * 5), which equals $975,000.
That means the gain on this transaction is 990,000 – 975,000, which equals $15,000. Therefore, when you file taxes, you would file $15,000 as the income amount. Because the depreciation tax rate is 20%, you will be taxed on 20% of that $15,000, or $3,000.
It’s important to mention that if the amount you file is larger than the total of the depreciation deductions, then the depreciation recapture equals the amount of the depreciation and will be taxed as ordinary income. The leftover amount will then be taxed as a capital gain.
Your true profit on a property is only realized after paying all taxes. If you want to determine the best time to sell a particular property or if you merely want to project cash flows for future investments and projects, you must understand the purpose and consequences of cost basis. Pay attention to improvements and depreciation, keep a careful record of your finances, and consult with a tax professional if you feel uncertain about anything.