Definition
Basis (often called cost basis) is the amount used for tax and accounting purposes to measure depreciation and determine taxable gain or loss when a property is sold. In most purchases, basis starts with what you paid to acquire the property, then changes over time as you make improvements or take depreciation.
How Basis Changes Over Time
Real estate basis is commonly tracked as adjusted basis: what you started with, plus increases (like capital improvements), minus decreases (like depreciation).
Common components
- Initial basis: purchase price plus certain acquisition costs (often excluding items like loan fees).
- Increases to basis: capital improvements that add value or extend useful life (e.g., roof replacement, major remodels).
- Decreases to basis: depreciation deductions taken (or allowed), casualty losses, and some credits.
- Land vs. improvements: land is typically not depreciable; the building/improvements portion generally is.
Why It Matters
Basis is a core driver of after-tax returns. It affects: (1) how much depreciation you can claim during ownership, and (2) how much taxable gain you recognize at sale. Investors also use “all-in basis†informally to describe total capital invested into a project (purchase + rehab + closing costs), which helps compare deals on a consistent cost-per-unit or cost-per-square-foot basis.
Investor Uses
- Underwriting renovations: track “all-in basis†to compare to ARV and projected stabilized value.
- Depreciation planning: estimate annual depreciation and tax shelter potential (subject to investor circumstances).
- Disposition analysis: forecast taxable gain, including potential depreciation recapture.
- Partnership accounting: basis affects how cash distributions and losses may be allocated (varies by structure).
Example
An investor buys a property for $1,000,000 and spends $150,000 on qualifying capital improvements. Over the hold period, the investor claims $120,000 of depreciation.
- Starting basis: $1,000,000
- Plus improvements: + $150,000
- Minus depreciation: − $120,000
- Adjusted basis: = $1,030,000
If the property sells for $1,300,000 (ignoring selling costs for simplicity), the gross gain would be $1,300,000 − $1,030,000 = $270,000.
Common Pitfalls
- Confusing repairs vs. improvements: routine repairs may be expensed; improvements generally increase basis.
- Not separating land value: land typically isn’t depreciable, which affects depreciation estimates.
- Ignoring depreciation recapture: depreciation lowers basis, which can increase taxable gain at sale.
- “All-in basis†vs. tax basis: investor shorthand may differ from tax accounting rules.