It’s surprising how many real estate investors manage to get their rental property cost basis wrong. The first thing to know is that cost basis, adjusted cost basis, and depreciation basis are three different things. In this quick post, we help you understand the differences, show you how to assign closing costs properly, and offer a free rental property cost basis spreadsheet for download.
Please remember that we do not offer accounting or tax advice. This article should be relied upon for informational purposes only.
#1 Calculate Your Original Cost Basis
Start with the full purchase price shown in the contract. For example, let’s say you recently bought a rental property for $250,000. It doesn’t matter if you paid all cash or financed it with a new mortgage, hard money loan, etc. You paid $250,000 so that’s your starting number.
You’ll next add some closing costs, but not others. Why? Because only certain closing costs can be capitalized, while others are fully expensed in the same year you purchased the property.
How to Handle Closing Costs
The following closing costs should be capitalized and added to your basis, but only if you paid them (not the seller), per IRS guidelines:
- Owner’s title insurance (not lender’s)
- Transfer taxes
- Legal and escrow fees
- Survey fees
- Recording fees
- Utility installation charges (these are not typical)
- Any seller owed items you agree to pay without being reimbursed (commissions, taxes, interest, improvements, etc.)
Add costs associated with all items listed above to your original $250,000 purchase price to arrive at your original cost basis.
Closing cost items you cannot add to your original cost basis include:
- Insurance premiums for casualty (fire, hurricane, etc.)
- Rent or utility charges for occupancy prior to closing
- Property taxes
- Loan and refinancing costs or fees (points, appraisal, etc.)
- Pre-paid interest on your loan(s)
- Lender’s title insurance
- Amounts placed in escrow to cover future expenses
The first three items on this list can be deducted as normal expenses for the year in which you acquired the property. Loan costs are not deducted but are instead amortized over the expected life of the loan. Amounts placed into escrow accounts are not deducted until the actual expenses are incurred and paid.
#2 Add Capital Expenses to Calculate Adjusted Cost Basis
Let’s say your original cost basis ended up at $254,500 after adding relevant closing costs to your purchase price. You’ll now want to add in any subsequent capital expenses to arrive at your adjusted cost basis. This would include costs for projects such as a new roof, major landscaping work, electrical system upgrades, kitchen renovation, new driveway, or the addition of an extra bedroom or new garage, among many others.
Capital expenses increase your cost basis because they are considered long-term improvements that have become integral parts of the property. For example, if you spent $20,000 on a new master bathroom, you’ll simply add this amount to the $254,500 basis to arrive at an adjusted cost basis of $274,500.
If your rental property was not immediately placed into service after purchase, meaning it wasn’t already occupied or at least ready to be occupied by a tenant, you’ll also capitalize these preparation costs by adding them to your adjusted basis. These might include items that are usually expensed, like minor repairs or cleaning charges.
If you spent $500 on repairs and then another $300 on cleaning before listing your rental property for rent, your adjusted cost basis will look like this:
- $250,000 purchase price
- + $4,500 closing costs
- + $20,000 bathroom renovation
- + $800 “make ready” costs
- = $275,300 adjusted cost basis
#3 Cost Basis for Depreciation is Different
It’s tempting to simply roll the $275,300 figure into a depreciation schedule and then take your deduction all the way to the bank. But that’s just not how it works. Land doesn’t depreciate and some portion of your $250,000 purchase price must be allocated to land value.
Assuming you did your bathroom renovation and rent preparation work in the same calendar year that you acquired the property, you can start with your $275,300 adjusted basis number. Then simply subtract a justifiable land value amount from the purchase price to arrive at your first year adjusted cost basis for depreciation.
For example, let’s say your county assessor allocated 25% of the property value to the land and 75% to the improvements on last year’s property tax bill. That means you’ll simply deduct 25% of $250,000 (or $62,500) from $275,300.
That leaves you with an adjusted cost basis for depreciation of $212,800 for your first calendar year of ownership. That amount depreciated over 27.5 years yields a tax deduction for depreciation of roughly $7,738 per full calendar year. Unless you closed on January 1, your first year depreciation deduction will of course be less.
Check out our related post for a deeper dive on how rental property depreciation works.