Rental Property Basis Calculation: Land, Building and Adjustments

Basis is different from equity

Equity is a financing concept: property value minus debt. Basis is a tax concept used for depreciation, casualty calculations and gain or loss. Paying down the mortgage increases equity but does not generally increase tax basis.

Market appreciation also does not automatically change basis. Basis changes through specific tax adjustments and transactions.

Build the initial cost file

Purchase price is the starting point for many acquisitions, but certain settlement and acquisition costs may be added to basis while other items are currently deductible, amortized or excluded. Escrow deposits for future taxes and insurance are not purchase basis.

Keep the closing statement, deed, contract, appraisal, legal invoices and allocation workpapers. The tax treatment of each closing line should be reviewed rather than applying one percentage to the entire statement.

Separate land from buildings

Land is not depreciable, so a combined purchase must be allocated between land and building. IRS guidance permits allocation using relative fair market values, and assessed values may be used as a basis for allocation when fair market values are uncertain.

A tax assessment is not automatically the only correct method, but the allocation should be reasonable, documented and consistent. Special components or personal property can require additional analysis.

Track improvements and depreciation

Capital improvements generally increase basis and are recovered through depreciation or upon disposition, subject to the applicable rules. Repairs may be currently deductible when they do not need to be capitalized.

Adjusted basis is reduced by depreciation allowed or allowable, not simply the amount the owner remembers claiming. Errors should be addressed with a tax professional rather than ignored until sale.

Conversions, gifts and exchanges need special rules

When a former personal residence becomes a rental, depreciation basis can be limited to the lower of adjusted basis or fair market value at conversion. Inherited, gifted and exchanged property can use other basis rules.

These situations are especially important because a wrong starting basis can affect years of depreciation and the eventual gain calculation. Obtain professional advice and preserve valuation support.

Rental Property Basis Calculation checklist

• Save the complete acquisition closing file
• Classify each settlement cost
• Allocate land and building with support
• Add capital improvements by date and asset
• Track cumulative allowed or allowable depreciation
• Update basis after exchanges or casualty events