How to Calculate Adjusted Cost Basis for a Rental Property

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Investing in a real estate property can be a great source of income and capital appreciation while also providing an owner with a tangible asset to take pride in. As any new owner will soon find out, real estate investing has a number of unique tax benefits and considerations. A key element of this tax planning is determining the Adjusted Cost Basis for a property which impacts the overall taxable gain an owner might have when selling the property.

For more on the broader tax implications of selling a real estate property, see Tax Implications of Selling a Rental Property – Gilbert Wealth

Calculating the Adjusted Cost Basis can be quite complex and this guide is not meant to be specific tax advice nor does it dive into every area of the calculation. Please consult with a qualified accountant for details related to your own situation.

The Basic Formula for Adjusted Cost Basis

Adjusted Cost Basis = Original Cost Basis + Items that Increase Basis - Items that Decrease Basis

Original Cost Basis

Plus Items that Increase Basis

Minus Items that Decrease Basis

Breakdown of the Adjusted Cost Basis Formula

Rental Purchase Price and Closing Costs

The Purchase Price is the actual amount you paid to buy the property and forms the baseline for calculating your adjusted cost basis. If you agreed to buy a property for $200,000, that is your purchase price.

In addition to the purchase price, your original cost basis also includes Closing Costs which are the fees and charges you paid to finalize the real estate purchase. These can vary significantly between locations, financing strategies, and terms of the sale. Expand the following section for a list of closing fees and charges you may incur:

Common Closing Costs

Loan Origination Fees: Charges by the lender for processing the loan application and underwriting the mortgage.
Appraisal Fee: The cost of a professional appraisal to determine the property’s market value.
Credit Report Fee: The fee for obtaining your credit report, which is used by the lender to assess your creditworthiness.
Title Insurance: Insurance that protects against any claims on the property’s title, ensuring clear ownership.
Title Search and Examination Fees: Costs associated with searching public records to verify the property’s title history and ownership.
Escrow Fees: Charges for the third party (escrow company) that handles the transfer of funds and documents between the parties involved in the transaction.
Attorney or Settlement Agent Fees: Legal fees for services provided by an attorney or settlement agent to facilitate the closing process.
Recording Fees: Charges for recording the new deed and other relevant documents with the local government.
Transfer Taxes: Taxes imposed by local or state governments on the transfer of property ownership.
Homeowners Association (HOA) Fees: Pro-rated fees for any applicable HOA dues or assessments.
Prepaid Property Taxes and Insurance: Upfront payments for property taxes and homeowners insurance, which may be required by the lender.
Survey Fee: The cost of a property survey to determine the property’s boundaries and dimensions.
Home Inspection Fee: The fee for a professional inspection to assess the property’s condition and identify any potential issues.
Mortgage Insurance Premium: If your down payment is less than 20%, you might need to pay mortgage insurance, which protects the lender in case of default.
Prorated Interest: Interest on the mortgage loan that accrues from the closing date to the end of the month.

Capital Improvements

Capital Improvements are loosely defined as any improvement that extends the useful life of an asset, significantly increases its value, or alters the use of the asset. Capital Improvements differ from regular expenses in that capital improvements are depreciated over time whereas regular expenses can be deducted against income in the year they are incur. Again, this distinction can be quite complicated so see your accountant for specific tax advice.

Some of the most common candidates for Capital Improvements are:

Appliances

Refrigerator
Washer
Dryer

Home Structure

Attic, wall, and floor insulation
Wiring upgrades
New roof
Storm windows and doors
Installing a new garage door
New Windows

Heating and air conditioning

New HVAC
Central air conditioning
A furnace
Duct work
A central humidifier
A filtration system

Plumbing improvements

Septic system
Water heater
Soft water system
Filtration system
Major pipe replacements

Property Additions

Shed
Deck or patio
Swimming pool
Additional Room

Additions and interior improvements

Built-in appliances
Room Renovations (Kitchen Remodel, Finishing a basement, etc.)
Flooring
Central Vacuum
Wall-to-wall carpeting
Security system
Major Painting

Improvements to your lawn and grounds

Landscaping
Driveway
Walkway
Fence
Retaining wall
Sprinkler system

Expensing Capital Improvement Exceptions

There are three rules that may allow an owner to expense, rather than depreciate, a capital improvement. While beyond the scope of this article, the three rules are as follows:

Section 179
Safe Harbor for Small Taxpayers
De Minimus Safe Harbor

Local Improvement Assessments

Local improvement assessments, often referred to as special assessments or property assessments, are charges imposed by local governments on property owners to fund specific public infrastructure projects or improvements within a defined area. These assessments are used to finance projects that provide direct benefits to the properties within the designated district. The projects can include a wide range of improvements such as road construction, street lighting, sidewalk repairs, sewer system upgrades, landscaping, and more.

Depreciation

Portions of the investment in the rental property are eligible for one of the most prized real estate tax benefits, Depreciation. Depreciation, in a nutshell, is the deduction against income of the cost of the investment over a set schedule called a recovery period. For example, if you spend $10,000 on a capital improvement with a recovery period of 5 years, you can deduct $2,000 against income each year for the next 5 years. If this $10,000 were an expense instead, you could deduct the full $10,000 in year 1.

The Recovery Periods for capital improvements are set by the IRS and range from a short as 3 Years to as long as 39 Years! Check out the following IRS Publication if you want to learn more: Publication 946 (2022), How To Depreciate Property | Internal Revenue Service (irs.gov)

Deferred Capital Gains

Deferred capital gains occur when an individual or entity sells a property (such as a rental property) and uses the proceeds to invest in a similar or “like-kind” property, as defined by Internal Revenue Service (IRS) regulations. By doing so, the capital gains tax liability that would have been incurred from the sale is deferred, allowing the investor to continue building wealth without an immediate tax obligation.

Proceeds from Condemnation or Easement Granting

Proceeds from condemnation or easement granting in real estate basis refer to compensation received by a property owner due to the government’s exercise of eminent domain or the granting of a property easement.

Reimbursements received or deductions taken from casualty or theft loss

Reimbursements received or deductions taken from casualty or theft loss refer to financial actions taken by property owners following damage or loss to their property due to unexpected events, such as natural disasters or theft.

Tax Forms and Resources

1. Schedule E (Form 1040): Schedule E is a supplemental form used to report rental income and expenses. It’s attached to your individual income tax return (Form 1040). On Schedule E, you report rental income, deduct allowable expenses (such as mortgage interest, property taxes, maintenance, and utilities), and calculate your net rental income or loss.

2. Form 4562: Form 4562 is used to claim depreciation and amortization deductions for various assets, including rental property. You use this form to report depreciation expenses for your rental property over its useful life and keep track of the current cost basis for a property.

Publication 551 (12/2022), Basis of Assets | Internal Revenue Service (irs.gov)

Publication 946 (2022), How To Depreciate Property | Internal Revenue Service (irs.gov)