Definition
Cost basis is the original value of a property for tax purposes. It typically equals the purchase price plus certain capitalized acquisition costs and is later adjusted for improvements, depreciation, and other changes.
Initial Cost Basis Calculation
- Purchase Price
- + Capitalized closing costs (legal fees, title insurance, recording fees)
- + Certain acquisition-related costs
- = Initial Cost Basis
The cost basis must then be allocated between land and improvements for depreciation purposes.
Adjusted Basis
Over time, cost basis becomes adjusted basis due to increases and decreases.
Increases to Basis
- Capital improvements
- Major renovations
- Certain legal or settlement costs
Decreases to Basis
- Accumulated depreciation
- Casualty loss deductions
- Insurance reimbursements
Role in Depreciation
The portion of cost basis allocated to improvements becomes the depreciable basis, which is depreciated over 27.5 years (residential rental) or 39 years (commercial property in the U.S.).
Role in Capital Gains Calculation
When a property is sold:
- Capital Gain = Sale Price – Adjusted Basis
Lower adjusted basis (due to depreciation) increases taxable gain, including potential depreciation recapture.
Example
An investor buys a property for $3,000,000 and capitalizes $100,000 in acquisition costs.
- Initial Cost Basis = $3,100,000
- Over time, $500,000 in depreciation is taken.
- Adjusted Basis = $2,600,000
If the property is sold for $4,000,000, taxable gain = $4,000,000 – $2,600,000 = $1,400,000.
Why It Matters
- Determines annual depreciation deductions.
- Affects after-tax cash flow modeling.
- Impacts capital gains and recapture at disposition.
- Important in partnership allocations and estate planning.
Common Pitfalls
- Failing to capitalize eligible acquisition costs.
- Improper land allocation.
- Not tracking capital improvements accurately.
- Ignoring basis adjustments in underwriting exit scenarios.