Whenever you acquire an asset such as a residential, rental or investment real estate, you have a cost basis associated with the acquisition. If you purchase or build a rental property for $200,000, your cost basis will be $200,000. If you subsequently remodel the property for $10,000, your new basis will be the original basis of $200,000, plus the amount you spend on converting the property, giving you an adjusted basis of $210,000. From the example, it is clear that additions or capital improvements increase the basis of a rental property, whereas depreciation and casualty losses decrease its basis. The adjusted basis is computed by taking into account all increases and decreases in the property's original basis. Determining the adjusted basis of a rental property is important because you will need it to calculate your gain or loss on sale, which in turn affects your taxable income.
Determine the original basis of the rental property. If you bought or built the property, the basis will be the purchase price or the cost of construction. If you acquired the property as a gift or by inheritance, your basis will be the fair market value on the date of acquisition, or the adjusted basis of the property in the hands of the person from whom you acquired it. Suppose you bought the property for $500,000 -- your original basis on the property is the purchase price.
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Determine additions or capital improvements made to the property. This will increase your basis by the amount spent on improving or converting the property. Suppose you spend $30,000 on upgrading the central heating system. Taking this addition into account, your adjusted basis now is $530,000 ($500,000 original basis, plus $30,000 spent on additions).
Calculate cost to sell the property. Selling costs increase the basis of the property and includes all costs incurred in disposing of the asset in a sale, such as commissions and fees paid to real estate agents, lawyers and accountants, as well as advertising expenses and any other costs involved. If your cumulative cost of sale is $10,000, the adjusted basis will increase to $540,000 ($530,000 old adjusted basis plus $10,000 cost to sell).
Calculate the cumulative depreciation on the property -- this will reduce your adjusted basis. Suppose you held the property for five years, and took depreciation of $20,000 every year. Your adjusted basis will be reduced by $100,000 ($20,000 depreciation per year multiplied by five years). Considering the cumulative depreciation on the property, the adjusted basis is $440,000 ($540,000 old adjusted basis minus $100,000 cumulative depreciation).
Determine cumulative depreciation on additions or capital improvements. If you depreciated the central heating system from Step 2 by $1,500 each year for two years, cumulative depreciation on additions or capital improvements will be $3,000 ($1,500 depreciation each year multiplied by two years). This will reduce your basis, giving you an adjusted basis of $437,000 ($440,000 old adjusted basis minus $3,000 cumulative depreciation).
Calculate gain on sale of rental property. If you sold the property for $600,000, your gain will be $163,000 ($600,000 amount realized minus $437,000 adjusted basis). Note than a higher adjusted basis gives a lower gain on sale, which may be beneficial for the taxpayer.