How to Determine Cost Basis for Rental Property?

Understanding the cost basis for rental property is crucial for landlords and real estate investors. It serves as the foundation for calculating depreciation deductions, determining capital gains or losses upon sale, and accurately reporting tax-related events. An incorrect basis could lead to overstated taxes or IRS scrutiny.

Determining the cost basis of a rental property is essential for calculating depreciation deductions, capital gains, and overall tax liability when you sell the property. The cost basis is essentially the amount you invested in the property and includes more than just the purchase price.

Below is a comprehensive breakdown of how to determine the cost basis of your rental property.

Step-by-Step Guide to Determine Cost Basis For Rental Property

1. Start with the Purchase Price

This is the amount paid for the property, including both land and building. The cost basis begins with the total purchase price of the property. This is the amount paid to acquire the property, including:

• The agreed-upon purchase price in the sale contract
• Any points paid to obtain a mortgage (in some cases)
• Real estate commissions (if paid by the buyer)

This number is your initial baseline.

2. Separate the Value of Land and Building

You cannot depreciate land—only the building. You must separate the value of the land from the value of the structure. The IRS requires you to depreciate only the value of the building, not the land. Therefore, you must split the total purchase price between:

• Land (non-depreciable)
• Building (depreciable over 27.5 years for residential real estate)

Use the county assessor’s tax records or an appraisal to allocate the proportion of land vs. building.

Example: If 20% of the total value is allocated to land, 80% will be allocated to the building (the depreciable portion).

How to Allocate:

• Use the property tax assessment that provides a land-to-building ratio.
• Alternatively, hire a qualified appraiser to allocate the values.

Example:

If the total property value is $400,000, and the county tax assessor says 25% is land and 75% is building, then:

• Land = $100,000 (non-depreciable)
• Building = $300,000 (depreciable)

3. Add Acquisition and Closing Costs

Certain purchase-related expenses can be added to your basis. These are costs directly tied to the acquisition of the property. You can increase your cost basis by adding certain purchase-related expenses, such as ;

• Title search and title insurance
• Recording fees and deed preparation
• Transfer or stamp taxes
• Legal and document preparation fees
• Surveys costs
• Abstract fees
• Real estate commissions (buyer’s side)

Note: Loan-related fees like mortgage interest, escrow payments, or property taxes are not added to basis—they’re typically deductible separately.

4. Include Capital Improvements

Any capital improvements made to the property after purchase increase your basis. These are costs that:

• Extend the useful life of the property
• Improve the property’s condition or value
• Adapt the property to a new use

Examples of Capital Improvements:

• Adding a garage or deck
• Installing a new roof, HVAC system, or flooring
• Renovating kitchens or bathrooms
• Upgrading electrical or plumbing systems

Keep all receipts, contracts, and permits—these records are critical for substantiating your adjusted basis if audited.

Note: Routine maintenance (like repainting or fixing a leak) does not affect your basis.

5. Subtract Accumulated Depreciation

Over time, your adjusted basis is reduced by the depreciation you’ve claimed (or were eligible to claim) during the rental period. As a rental property owner, you are entitled to depreciate the building portion of the cost basis over 27.5 years. Each year you take a depreciation deduction, you reduce your adjusted basis.

Even if you don’t claim depreciation, the IRS still assumes you did—and you must reduce your basis accordingly. This can result in a higher taxable gain when you sell.

Example Calculation:

If your building basis is $275,000, and you’ve taken $55,000 in depreciation over 10 years, your adjusted basis is:

$275,000 (building) + capital improvements − $55,000 (depreciation)

6. Final Cost Basis Formula

Here’s the final formula for determining your adjusted basis:

Adjusted Basis =

(Purchase Price + Acquisition Costs + Capital Improvements)  –  Accumulated Depreciation

Or, more visually:

Adjusted Basis = Original Building Cost + Capital Improvements + Eligible Closing Costs – Depreciation

Example

• Purchase Price: $300,000
• Allocation: 80% Building ($240,000), 20% Land ($60,000)
• Closing Costs: $5,000
• Capital Improvements: $15,000
• Depreciation Taken: $40,000

Adjusted Basis =
$240,000 (building) + $5,000 + $15,000 − $40,000 = $220,000

This adjusted basis is used to calculate capital gains when the property is sold.

Why Adjusted Basis Matters

The adjusted basis of a rental property is not just a technical accounting term—it plays a central role in how much tax you owe (or save) over the life of owning, using, and eventually disposing of the property. It evolves over time from your original cost basis as you make improvements, take depreciation, or incur losses. Knowing your adjusted basis is essential for several tax-related reasons.

1. Cost Basis Determines Capital Gain or Loss at Sale

Perhaps the most important reason the adjusted basis matters is its use in calculating capital gain or loss when you sell the property.

Formula:

Capital Gain = Selling Price − Adjusted Basis − Selling Costs

If your adjusted basis is lower (because of depreciation), your capital gain will be higher, and you’ll owe more taxes on the sale. Conversely, if you made substantial improvements that increased the basis, your gain (and tax liability) will be reduced.

2. Cost Basis Impacts on Depreciation Deductions

The adjusted basis is used to calculate depreciation, which is a key tax benefit of owning rental property. Depreciation allows you to recover the cost of the building over 27.5 years, reducing your annual taxable income.

• The higher your initial basis in the building, the larger your yearly depreciation deductions.
• If you fail to account for capital improvements, you might miss out on deductions.
• If you overstate basis, you could face penalties for excessive deductions.

Depreciation is recaptured at sale—so failing to account for it properly can lead to unexpected tax bills.

3. Affects 1031 Like-Kind Exchange Calculations

In a like-kind exchange (Section 1031), where you defer paying tax by reinvesting in a similar property, your adjusted basis carries over to the new property.

• Knowing the correct basis ensures that deferred gains and depreciation are properly transferred.
• Errors in adjusted basis can result in overpaying taxes on the replacement property or IRS penalties.

4.  Key in Casualty Loss and Insurance Claims

If your rental property is damaged (by fire, flood, etc.), the adjusted basis helps determine:

• The amount of deductible loss for tax purposes.
• Whether insurance reimbursements are taxable or result in gain.

A high adjusted basis may minimize taxable gain from insurance proceeds. A low adjusted basis may increase it.

5. Cost basis for inherited property & Estate Planning

If the property is inherited, the basis is “stepped up” to the fair market value at the date of death—which can eliminate prior capital gains. However, for gifted properties, the donee inherits the donor’s adjusted basis.

Understanding how basis adjustments work helps:

• Optimize gift vs. inheritance strategies.
• Prepare accurate estate and gift tax filings.
• Prevent heirs from unknowingly triggering high capital gains taxes.

6. Cost basis Helps Avoid IRS Scrutiny

Improper reporting of adjusted basis is a common red flag during IRS audits. Mistakes such as:

• Forgetting depreciation deductions
• Failing to reduce basis after insurance payments
• Overstating capital improvements
  …can result in penalties, interest, and back taxes.

Keeping detailed records of how your basis was adjusted over the years protects you during an audit and ensures tax compliance.

Examples of Cost Basis

• Purchase Price: $350,000
• Allocation: 80% Building = $280,000; 20% Land = $70,000
• Acquisition Costs: $6,000
• Capital Improvements: $25,000 (new kitchen and HVAC)
• Depreciation Taken: $40,000

Adjusted Basis =
$280,000 (building) + $6,000 + $25,000 − $40,000 = $271,000

When the property is sold, this $271,000 basis will be subtracted from the sale price (minus selling expenses) to calculate capital gain or loss.

Final Tips

• Keep detailed records of all expenses, improvements, and depreciation schedules.
• Consult a qualified tax professional for complex scenarios like inherited or exchanged properties.
• Use Form 4562 to report depreciation and maintain documentation of basis for IRS compliance.

Frequently Asked Questions (FAQs)

1. What is Cost Basis?

Cost basis is the original value of an asset for tax purposes. It is typically the purchase price of an investment or property, plus any associated costs (like commissions or fees), and is used to determine capital gain or loss when you sell the asset.

2. Why is Cost Basis Important?

Cost basis directly affects how much capital gains tax you pay.

• Higher basis = Lower taxable gain
• Lower basis = Higher taxable gain
  It also plays a key role in calculating depreciation, losses, and inheritance/gift taxes.

3. What Costs Can Be Included in the Basis?

For real estate or investments, the basis can include:

• Purchase price
• Broker’s commissions
• Closing costs
• Legal and title fees
• Capital improvements (for real estate)
• Acquisition fees (for mutual funds or stocks)

4. How Do I Determine Cost Basis for Stocks?

For stocks, basis is typically the purchase price per share plus commissions. If you acquired shares over time, use one of the IRS-approved methods:

• FIFO (First-In, First-Out)
• Specific Identification
• Average Cost (mutual funds only)

5. How Do I Determine Cost Basis for Real Estate?

Start with the purchase price, add:

• Closing and acquisition costs
• Capital improvements
  Then subtract:
• Any depreciation (for rental property)
• Insurance reimbursements
• Casualty or theft losses

6. What Happens to Cost Basis When I Inherit an Asset?

Inherited assets receive a step-up in basis to the fair market value (FMV) on the date of the decedent’s death. This reduces potential capital gains if the asset is sold shortly thereafter.

7. What is the Cost Basis of Gifted Property?

If you receive a gift, your basis is generally the donor’s adjusted basis.
However, if the FMV at the time of the gift is less than the donor’s basis, special rules apply when calculating gain or loss.

8. What if I Can’t Find My Original Cost Basis?

Try:

• Reviewing brokerage statements, HUD-1 settlement forms, or closing disclosures
• Contacting your financial advisor or broker
• Using IRS-permitted estimates (but with caution and documentation)

The IRS expects reasonable effort to determine basis. Guessing without records may trigger audit concerns.

9. Can My Cost Basis Be Adjusted Over Time?

Yes. Your adjusted basis changes if you:

• Make capital improvements
• Claim depreciation (real estate)
• Incur losses or insurance recoveries
  These events increase or decrease the basis depending on the situation.

10. How Do I Report Cost Basis to the IRS?

• For investments: Use Form 8949 and Schedule D when reporting capital gains and losses.
• For property: Include basis and adjusted basis when calculating gain/loss on Schedule D or Form 4797 (for rental/business property).

11. How is the cost basis determined for a house placed in an irrevocable trust?

The cost basis of a house in an irrevocable trust depends on how the trust was structured and when and how the house was transferred. Typically:

• If the house is transferred as a gift during the grantor’s lifetime, the beneficiaries generally receive the grantor’s original basis (also called carryover basis).
• If the property is transferred to beneficiaries after the grantor’s death, the basis usually receives a step-up to fair market value (FMV) as of the date of death—but only if the trust is not a grantor trust and qualifies under estate inclusion rules.

12. What is HIFO (Highest In, First Out) cost basis, and how does it work?

HIFO, or Highest In, First Out, is a method of calculating cost basis for selling assets—commonly used with investments like stocks or cryptocurrency. Under this method, when you sell part of your holdings, you designate the units or lots with the highest purchase cost to be sold first. This strategy is used to minimize capital gains (and therefore taxes), because:

Capital Gain = Selling Price − Cost Basis
A higher cost basis = a lower gain.

13. How do I determine the cost basis of shares purchased through an ESPP      (Employee Stock Purchase Plan)?

The cost basis of ESPP shares is generally the actual price you paid for the shares, which often includes a discount from the market price, plus any ordinary income that must be reported due to the discounted purchase.

Cost Basis = Purchase Price + Ordinary Income (if applicable)

The purchase price is often 85% (or another discounted percentage) of the lower of:

• The stock price at the beginning of the offering period, or
• The stock price at the end of the purchase period.

14. How is the cost basis of RSU shares determined?

The cost basis of RSU shares is the fair market value (FMV) of the stock on the vesting date—not the date they were granted.

Cost Basis = FMV on Vesting Date × Number of Shares Vested

This FMV amount is also typically reported as ordinary income on your W-2 in the year of vesting.

15. Is the RSU income included in my W-2?

Yes. When RSUs vest, the value of the shares is:

• Included in your W-2 wages for the tax year.
• Subject to federal income tax, Social Security, Medicare, and possibly state tax.

Since you’ve already paid tax on that value, it becomes your initial cost basis in the shares.

16. How is the cost basis of my RSU shares shown on E*TRADE?

On E*TRADE, the cost basis for your RSU shares may be displayed as $0 on your Form 1099-B, even though you already paid tax on the value at vesting. This is because brokers often report “unadjusted” basis to the IRS to avoid duplicate income reporting.

Important: You need to manually adjust the basis when filing your taxes.

17. What is the correct cost basis for RSUs on E*TRADE?

Your correct cost basis is the Fair Market Value (FMV) on the vesting date of the RSUs. Correct Cost Basis = FMV on Vesting Date × Number of Shares Vested.

 This amount is also included in your W-2 income (Box 1) from your employer, and you’ve already paid ordinary income tax on it.

18. How do I calculate the cost basis for shares purchased through an ESPP?

To calculate the cost basis of your ESPP shares, you need to consider the actual purchase price you paid, which often includes a discount (typically up to 15%), and then add any ordinary income reported on your W-2 (if applicable).

Basic Cost Basis = Purchase Price per Share × Number of Shares Purchased
Adjusted Cost Basis = Basic Cost Basis + Ordinary Income (if included in W-2)