The basics of property Cost Basis

Basis Adjustment

Cost Basis (Original Basis):

This is generally what you paid for the property, including the purchase price plus certain settlement fees and closing costs that weren't deducted elsewhere. Examples include:

• Abstract fees
• Charges for installing utility services
• Legal fees (related to purchase)
• Recording fees
• Surveys
• Transfer taxes
• Title insurance
• Any amounts the seller owed that you agreed to pay (e.g., back taxes or interest).

Adjusted Basis:

Your basis increases or decreases over time.

Increases to Basis: These make your basis higher, which reduces your potential taxable gain when you sell. The most common increases are for capital improvements. These are distinct from routine repairs and maintenance. A capital improvement must:

• Add value to your home.
• Prolong its useful life.
• Adapt it to new uses.
• Examples: Adding a room, installing a new HVAC system, paving the driveway, replacing the entire roof, installing new built-in appliances, significant landscaping additions. (Repainting or fixing a leak are generally considered repairs, not capital improvements).
• Special assessments for local improvements (e.g., streets, sidewalks).

Decreases to Basis: These make your basis lower, which increases your potential taxable gain when you sell. The most common decreases include:

• Postponed gains from the sale of a previous home (under old rules before 1997).
• Deductible casualty losses claimed.
• Insurance reimbursements received for casualty losses (if not reinvested in repairs/restoration).
• Residential energy credits claimed (some, not all).
• Depreciation claimed if you used part of your home for business or rental purposes.

Tax Impacts

Always consult your tax advisor to determine the actual tax implications for your specific situation.

Tax Impact on Sale of Primary Residence (Capital Gains)

The tax law provides a significant benefit for homeowners selling their primary residence:

Section 121 Exclusion (Home Sale Exclusion):

• What: If you meet the eligibility tests, you can exclude a large amount of capital gain from your income.
• Exclusion Amounts:
  • Up to $250,000 of gain if filing single (or married filing separately).
  • Up to $500,000 of gain if married filing jointly.
• Eligibility Tests: To qualify, you generally must meet both:
  • Ownership Test: You owned the home for at least two years during the five-year period ending on the date of sale.
  • Use Test: You lived in the home as your primary residence for at least two years during the five-year period ending on the date of sale. (The two years do not have to be continuous).
• Frequency: You can generally only claim this exclusion once every two years.
• Partial Exclusion: If you fail to meet the ownership, use, or two-year frequency requirements due to specific unforeseen circumstances (like a change in health, place of employment, or other IRS-defined events), you may qualify for a partial exclusion.
• Impact of Basis: You calculate your gain as (Selling Price - Selling Expenses - Adjusted Basis). Even if you expect your gain to be below the exclusion limit, calculating your adjusted basis is essential to confirm this. If your gain exceeds the exclusion amount, the excess is taxed as a capital gain.

Tax Impact on Sale of Secondary Home (Capital Gains)

Selling a secondary home (like a vacation home or property held purely for investment that isn't rented out) follows different rules:

No Home Sale Exclusion: The $250,000/$500,000 Section 121 exclusion generally does not apply to the sale of a secondary residence unless it met the primary residence use test for periods within the 5-year lookback (which can lead to complex partial exclusion calculations, especially if depreciation was taken).

Capital Gains Tax Applies: Any profit (gain) from the sale is subject to capital gains tax.

• Gain Calculation: Gain = Selling Price - Selling Expenses - Adjusted Basis.
• Tax Rate:
  • Short-Term Capital Gain: If you owned the property for one year or less, the gain is taxed at your ordinary income tax rate.
  • Long-Term Capital Gain: If you owned the property for more than one year, the gain is taxed at preferential long-term capital gains rates (currently 0%, 15%, or 20% depending on your overall taxable income).
• Impact of Basis: Basis adjustments are critical for secondary homes. Every dollar you can legitimately add to your basis through capital improvements directly reduces your taxable gain upon sale, saving you tax dollars at the applicable capital gains rate. Meticulous record-keeping of improvements is crucial.

Losses: Unlike primary residences where losses are generally not deductible, if the secondary home was held purely for investment purposes (not personal use), a loss on the sale may be deductible as a capital loss, subject to limitations. Losses on secondary homes primarily for personal use (like a vacation home) are generally not deductible.

Capital Improvements and Documentation

Examples of Capital Improvements vs. Repairs

Recommended Documentation for Home Improvements

Example: Cost Basis Calculation Over 20 Years (Through Sale in 2025)

Here's a real example of how a homeowner tracked their cost basis through the sale of their property:

Final calculation for 2025 sale with accurate records:

‍Sale price: $800,000

Adjusted basis: $488,000

Capital gain: $312,000

Without proper documentation of improvements:

‍Sale price: $800,000

Adjusted basis: $308,000 (only purchase price + closing costs)

Capital gain: $492,000

Tax Impact:

For a married couple filing jointly:

• With records: $0 tax (covered by $500,000 exclusion)
• Without records: No tax (still under $500,000 exclusion)

For a single filer:

• With records: $62,000 subject to capital gains tax ($312,000 - $250,000 exclusion)
• Without records: $242,000 subject to capital gains tax ($492,000 - $250,000 exclusion)At a 15% capital gains rate, this could mean paying an additional $27,000 in taxes ($36,300 vs. $9,300) simply due to missing documentation.

Remember: It’s important to keep detailed records of all improvements, including receipts, contracts, and before/after photos, to substantiate basis adjustments in case of an IRS audit.