How to Determine the Cost Basis of Your Rental Property for Depreciation

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Many landlords avoid learning the real estate tax code, and for good reason. 

The IRS has highly complex rules for reporting your financials. These are usually better understood by a tax professional or tax preparation software. However, grasping the basic ideas behind tax terms will help you stay involved and ensure the best tax outcomes.

One potentially confusing term used frequently in the tax code is “cost basis,” which is sometimes referred to as “unadjusted basis.” Cost basis is how much property is worth for tax purposes. It is necessary for depreciating your capital assets.

Any long-lasting asset has a cost basis, including equipment, furniture, and buildings.

However, cost basis isn’t always as simple as checking the price tag. It’s worth learning the details of calculating cost basis to prevent an IRS audit.

Here are four simple steps for determining the cost basis of your rental property.

Step 1: Start with the Purchase Price

The first step to determining the cost basis of your property is to find the purchase price. For the purposes of this article, we’ll focus on buildings. Locate the transaction details and find out what you originally paid for the building.

The purchase price of other assets (like personal property) might be harder to track down. For this reason, you must keep careful records and hold onto receipts for all purchases related to your rental business.

What if I Didn’t Buy My Property?

There are several circumstances in which you might own property but never actually purchased it. For example, you may have:

  • Received the property as a gift or inheritance
  • Exchanged it for a similar property in a like-kind exchange
  • Converted a property from personal to rental use
  • Built it yourself

In these cases, different rules apply for determining the cost basis. Usually, you will need to research the approximate fair market value of the property at the time you acquired it and substitute it for the purchase price.

Step 2: Subtract Cost of Land

Next, subtract the cost of land from the property’s purchase price.

This step is necessary because land is not a depreciable asset. The logic here is that land isn’t manufactured and won’t wear out or lose value over time. Therefore, you can’t depreciate the cost of land with your building.

Often, property sellers will include the cost of land with the rest of the property as a lump sum for the new owner. In this case, you should seek the real estate appraisal or land valuation to determine how much to subtract.

Step 3: Add Related Expenses

After you subtract the cost of land, the next step is to add a few expenses related to the purchase of the building. Add any expenses that fall into these five categories:

  • Facilitative costs – Facilitative costs are expenses involved in pursuing your purchase. They mostly include transaction costs: application fees, appraisal costs, professional tax advice, inspection fees, broker’s commissions (if you paid them), etc.
  • Remaining mortgage – If you purchased a building with an amount still left to be paid on its mortgage, include this cost.
  • Real estate taxes – These are treated as part of the basis.
  • Expenses incurred before the building was put in service – Repairs or other expenses you do before the building is ready to rent must be depreciated, so add them to the cost basis. Note: You can’t use the start-up expense deduction for expenses related to the building purchase.
  • Improvements – These permanently improve the value of your property, so they are included in the cost basis (e.g., installing a new HVAC system).

Step 4: Don’t Add These Expenses

The following expenses may seem to be related to the building purchase, but they should NOT be included:

  • Investigatory costs (Expenses used to determine whether to buy the property or which one to buy)
  • Loan expenses
  • Fire insurance

Understanding Rental Tax Terms

There are many more details to learn about cost basis and depreciation. Although depreciation is complex, you don’t need to know everything to get a general idea of how it works. By investing a little time into understanding depreciation deductions and other tax concepts, you can be much more active in completing your rental taxes.