How to Calculate Adjusted Basis on a Rental Property

Adjusted basis on a rental property is generally your original cost, plus certain purchase costs and capital improvements, minus the depreciation you have claimed or were entitled to claim. That number is subtracted from your net sale proceeds to find your gain. It matters whether you sell outright or plan a 1031 exchange, because it determines how much gain is being deferred and how much depreciation recapture sits inside it.

Owners often assume the starting point is simply the price they paid. In practice the figure moves every year you own the property, and it can be very different from the number in your head. Getting it right before you list is one of the most useful pieces of preparation you can do with your CPA.

What goes into the starting basis?

For a property you bought, the starting point is usually the purchase price plus certain costs of acquiring it. Commonly included items are:

• ›Title insurance and settlement fees paid as the buyer.
• ›Recording fees and transfer taxes you paid at purchase.
• ›Legal fees and survey costs tied to acquiring the property.
• ›Amounts you agreed to pay on the seller's behalf, such as back property taxes.

Costs of getting the loan, such as points and lender fees, are generally treated differently and are not added to basis. Your closing statement from the purchase is the best source document, so find it now if you can.

If you did not buy the property in an ordinary purchase, the starting point is different:

• ›Acquired through a prior 1031 exchange. Basis generally carries over from the property you gave up, adjusted for any cash you added or boot you received. This is why an owner who has exchanged several times can have a very low basis in a valuable property.
• ›Inherited. Basis is generally the fair market value at the date of death, often called a step up.
• ›Received as a gift. Basis is generally the donor's adjusted basis, with special rules if the property is worth less than that.
• ›Converted from your home to a rental. For depreciation, basis is generally the lower of your adjusted basis or fair market value on the date of conversion.

Why do land and building have to be separated?

Land is not depreciable. Only the building and certain improvements are. When you bought the property, the total basis should have been split between land and building, often using the ratio on the property tax assessment or an appraisal. That split controls how much depreciation you could take. It does not change the total basis, but it does affect how much has been depreciated, and therefore how much is subtracted later.

Which costs are capital improvements and which are repairs?

Capital improvements are added to basis. Repairs are deducted as expenses in the year you pay them and are not added. The general test is whether the work betters the property, restores it, or adapts it to a new use.

• ›Usually improvements: a new roof, a full kitchen or bathroom remodel, an addition, new HVAC, replacing all the windows, paving a driveway.
• ›Usually repairs: fixing a leak, patching drywall, repainting between tenants, replacing a broken window pane.

Improvements are typically depreciated on their own schedule, so each one adds to basis and is then reduced by its own depreciation over time. Keep the invoices. Without records, an improvement you paid for may be difficult to support.

What gets subtracted?

The main subtraction is depreciation. The rule that surprises people is that basis is reduced by depreciation allowed or allowable. If you were entitled to depreciation and never claimed it, basis is generally still reduced as if you had. Missing depreciation is a question to raise with your CPA well before a sale, because there can be ways to address it.

Other common subtractions include:

• ›Casualty losses you deducted, and insurance payments received for damage.
• ›Certain credits or rebates tied to the property, such as some energy related incentives.
• ›Easement payments received, in some cases.

A worked example, with illustrative figures

These numbers are illustrative only and are not drawn from any real property or tax return.

An owner bought a rental for 400,000 dollars and paid 8,000 dollars of qualifying purchase costs. Starting basis is 408,000 dollars, split for illustration as 100,000 dollars of land and 308,000 dollars of building.

Over the years the owner replaced the roof for 22,000 dollars and remodelled the kitchen for 30,000 dollars. That adds 52,000 dollars, bringing basis before depreciation to 460,000 dollars.

Depreciation claimed on the building and the improvements totals 150,000 dollars. Adjusted basis is now 460,000 dollars minus 150,000 dollars, which is 310,000 dollars.

The owner sells for 700,000 dollars and pays 42,000 dollars in selling costs. The amount realized is 658,000 dollars. The realized gain is 658,000 dollars minus 310,000 dollars, which is 348,000 dollars. Of that, the 150,000 dollars attributable to depreciation is generally treated differently from the rest of the gain and may be taxed at a different rate if recognized.

In a fully deferred 1031 exchange, none of that gain would be recognized at the time of the sale. It would generally carry into the replacement property through a lower basis, and the depreciation history would come with it.

Why does adjusted basis matter before a 1031 exchange?

Knowing the number early helps you and your advisers answer practical questions:

• ›How much is at stake. The gain you would defer is the measure of what the exchange is worth to you.
• ›What boot would cost. If you take some cash out or reduce your debt, gain is generally recognized up to the amount of boot, but never more than the realized gain.
• ›What the replacement basis will be. That determines how much depreciation you may take on the new property.
• ›Whether a sale at a loss is possible. If basis is above the net sale price, an exchange would defer a loss you might prefer to use now.

Where do you find the records?

Start with the purchase closing statement, prior tax returns showing depreciation schedules, receipts for improvements, and any Form 8824 from earlier exchanges. If records are incomplete, your CPA may be able to rebuild the history from returns and county records. The earlier you start, the less likely a missing invoice becomes a problem near closing.

This article is general education, not tax advice. Basis rules have exceptions that depend on your facts, so confirm your own figure with your CPA, and walk through how it affects your exchange with your Qualified Intermediary before you sign a sale contract.