All About That Basis: Real Estate Edition

The purchase of real estate property, whether for investment, business or personal use, has few immediate tax implications. However, expenses incurred in purchasing or building real estate property, regardless if the property is used for business or personal use, will have future tax consequences. Whether you’re a first time home buyer or want to invest in rental property, you should be aware of your basis and what it means to you.

What is Basis?

According to the IRS, basis is generally the amount of your capital investment in property for tax purposes which is used to figure depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange, or other disposition of the property. There are several rules that determine the basis of real estate property but as a general rule your basis is the original cost. To make this concept easier to understand, lets use an example.

John is a single guy in his 20’s working as an accountant (I wonder why John is single). John has saved up $20,000 for a 10% down payment for the purchase of his first home. Ignoring closing cost and other expenses incurred in the purchase of his new home, John paid $20,000 and took out a mortgage of $180,000. What is John’s basis? If you said $200,000 you would be correct. Now, if you said $20,000 then you may have been thinking about John’s equity in his new home. John’s equity is calculated by taking the fair market value of the home and subtracting any outstanding debt ($200,000 – $180,000). John’s basis, however, is simply the total purchase price of the of the home.

Why do I care about basis?

So why do we care about basis in a real estate property if generally it has no present tax implications? Besides the use of the occasional cocktail party anecdote about the size of his basis (Yes John is still single and I don’t understand why) he has no current tax benefit. Even though the original cost basis of John’s new home has no immediate tax consequence, it is important to understand how his basis will impact future taxable events. Once again, lets look at an example.

Let’s say John finds a girl who appreciates his dry humor and he convinces her to marry him (and of course, she happens to be an accountant as well). John decides his place is too small for him and his wife and he wants to buy a larger home. Some time has passed since he purchased his first home and the value of his home has increased significantly. John received $275,000 at closing: $100,000 went to the payoff of the existing mortgage, $100,000 went to the purchase of his new home and $75,000 went into his personal checking account (not a bad day for John). What is John’s realized gain on the sale of his home? If you said $75,000 you would be correct! The gain is calculated by taking the total proceeds of the sale of his home less his original cost basis ($275,000 – $200,000). Notice how the mortgage has no impact on the gain or loss from the sale of his home.

So why do we care about John’s $75,000 gain on the sale of his home? Because the sale of his home can cause a taxable event which could result in significant tax liability. Improper planning or failure to track the basis of real estate property can result in higher unexpected tax liability. In this case, John would most likely qualify for an exclusion of the total $75,000 gain resulting in zero tax consequences. However, each tax situation is unique and may result in an alternative outcome. This is why you should be all about that basis.

Overview:

This blog post is only a drop in the bucket when it comes to basis rules in real estate taxation. However, it is important to understand what basis is and how it impacts your future tax liability. If you get anything out of this post it’s this; there are many events and circumstances that may impact your adjusted tax basis in your real estate property which will ultimately increase or decrease your tax liability upon disposition. If you can understand that concept then you can use tax planning tools to reduce, defer or more accurately predict your future tax liability.

If you have questions about your specific tax situation, consult your CPA.