Some real estate investors mistakenly believe that the “cost basis” of property is its purchase price. However, cost basis isn’t as clear cut as it might seem.
Understanding the difference between the two can make the difference between paying too much in taxes, or paying a fair share.
- Three types of cost basis for a rental property are original, adjusted, and depreciation cost basis.
- Original cost basis is used to calculate tax on capital gains.
- Adjusted costs basis is used to anticipate the amount of capital gains tax due when a rental property is sold.
- Cost basis for depreciation is used to calculate depreciation recapture tax.
What is the cost basis for a rental property?
There are actually three types of costs basis for a rental property that real estate investors use:
- Original cost basis
- Adjusted cost basis
- Depreciation costs basis
In the following sections, we’ll explain the differences and provide examples of how to calculate the different types of cost basis for a rental property.
Original cost basis for a rental property
The original cost basis of a rental property is the purchase price plus certain closing costs that must be capitalized instead of expensed.
As the IRS explains, generally the only closing costs for a rental property that can be expensed or deducted from rental income are interest, certain mortgage points, and deductible real estate taxes.
Other closing costs must be added to the original costs basis of the rental property, including:
- Abstract fees
- Legal fees
- Recording fees
- Transfer taxes
- Title insurance
- Charges for installing utility services
- Customary seller expenses that the buyer agrees to pay, such as unpaid property taxes or a real estate sales commission
Here’s an example of how to calculate the original cost basis of a rental property. Let’s assume a real estate investor purchased a 3-bed, 2-bath single-family rental home in Memphis listed for sale on the Roofstock Investment Property Marketplace for $130,000.
The beginning number for calculating the original cost basis is the purchase price of the home, regardless if a buyer pays cash or finances the purchase with a 25% down payment and obtains a rental property loan for the balance.
According to the Freddie Mac closing costs calculator, estimated closing costs are about $6,346. The cost of $975 for discount points and $164 for prepaid interest are the only two fees that can be expensed, so the remaining closing costs of $5,207 must be added to the original cost basis:
- $130,000 purchase price + $5,207 closing costs = $135,207 rental property cost basis
Adjusted cost basis for a rental property
Capital expenses that add value to the property are then added to the original cost basis of the rental property to calculate the adjusted cost basis. Common capital expenses for a rental property may include costs such as:
- New roof installation
- Replacing the heating and cooling system
- Major electrical or plumbing work
- Kitchen and bathroom renovations
- Significant landscape improvements, such a installing a backyard deck or new driveway
- Creating additional rentable square footage such as constructing another bedroom or converting a basement or attic into a studio apartment
As a rule of thumb, capital expenses increase or adjust the original cost basis of a rental property because they are long-term improvements that add value. On the other hand, routine maintenance such as fixing a plumbing leak or mending a torn carpet keep the property in its original condition.
In the real world, capital expenses with a rental property can occur throughout the holding period. That means the adjusted cost basis can vary from one year to the next.
For the purposes of this example, we’ll assume that the investor spent $10,000 on a new roof immediately after closing escrow. The adjusted cost basis would look something like this:
- $130,000 original purchase price + $5,207 closing costs + $10,000 new roof = $145,207 adjusted cost basis
Depreciation costs basis for a rental property
Depreciation is an annual income tax deduction real estate investors take as an allowance for the wear and tear, deterioration, or obsolescence of a rental property. The depreciation period for residential real estate is 27.5 years, or 3.636% of the property value per year.
The cost basis used for depreciation of a rental property is different from the original cost basis and the adjusted basis, because land does not depreciate. To determine the cost basis of a rental property for depreciation purposes, the value of the land or lot must be subtracted from the adjusted basis.
For example, assume that the value of the lot the single-family home sits on is $15,000, according to the county assessor. That means the cost basis for depreciation is $130,207:
- $145,207 – $15,000 lot value = $130,207 depreciation cost basis
To calculate the annual depreciation expense, simply divide the depreciation cost basis by 27.5 years or multiple the depreciation cost basis by 3.636%:
- $130,207 depreciation cost basis / 27.5 years = $4,734 annual depreciation expense
- $130,207 depreciation cost basis x 3.636% = $4,734 annual depreciation expense
When a rental property is sold, a real estate investor must “recapture” the depreciation expense taken over the holding period. Recaptured depreciation is treated as ordinary income and taxed based on an investor’s federal income tax bracket, up to a maximum tax rate of 25%.
If an investor held the rental property for five years before selling, the tax paid on depreciation recapture would be $5,918, assuming the maximum tax rate:
- $4,734 annual depreciation expense x 5 years = $23,670 total depreciation to recapture
- $23,670 x 25% maximum tax rate = $5,918 tax paid on depreciation recapture
Cost basis for capital gains on a rental property sale
When a rental property is sold, the adjusted cost basis is used to calculate the profit on the sale and the capital gains tax liability.
To illustrate, assume that our investor holds the single-family rental home for 5 years before selling for a net sales price of $165,430 after deducting seller closing costs and the real estate commission.
The capital gain is calculated by deducting the adjusted cost basis of the rental property from the net sales price:
- $165,430 net sales price
- $145,207 original cost basis
- $20,223 capital gain
The long-term capital gains tax rate for property held longer than one year is 0%, 15%, or 20%, depending on the federal tax bracket an investor is in.
Assuming the investor in this example is in a top tax bracket, the capital gains tax due on the sale of the rental property would be $4,045:
- $20,223 capital gain x 20% capital gains tax = $4,045 capital gains tax liability
Keeping track of rental property cost basis
Accurately tracking the cost basis of a rental property can be much more complicated in the real world of real estate investing.
For example, because rental property is rarely bought or sold on the first or last day of the year, depreciation in the first year is calculated in months instead of the entire year. Capital expenses don’t always occur immediately after close of escrow, and different improvements to a rental property have different depreciation schedules.
While the residential rental property and most improvements are depreciated over a period of 27.5 years, other depreciation recovery periods occur much faster:
- Appliances such as stoves and refrigerators . . . . . . 5 years
- Carpets and furniture used in a rental property . . . 5 years
- Office furniture such as desks and files . . . . . . . . . . 7 years
- Landscaping and shrubbery . . . . . . . . . . . . . . . . . . . 15 years
- Roads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 years
Although it’s possible to keep track of changes to the cost basis of a rental property, many investors opt for an easier and more accurate system. Stessa makes tracking real estate investment simple because the software was designed by real estate investors for fellow real estate investors.
Stessa automates income and expense tracking, and records each transaction to the correct line item on the rental property chart of accounts.
The property cost basis and accumulated depreciation are automatically updated on the real estate balance sheet, and the estimated valuation for single-family rental homes is updated monthly based on multiple factors.
Instead of having to make an educated guess, real estate investors who sign-up for a free account with Stessa have a more accurate idea of owner’s equity each and every month.