How to calculate cost basis can be a confusing concept to those who contemplate selling their real estate. Along with fair market value and holding period, cost basis represents one of three key components in identifying the amount of potential tax that may be due on the sale of the property.
Unfortunately, how to calculate cost basis is not a common concept ingrained in us through our normal day-to-day educational experience. However, it very quickly becomes very real as we explore various real estate exit and transition strategies.
A good place to start in developing an understanding how to calculate cost basis is by refining capital gain. What are capital gains and how do they apply to real estate? In simpleest terms, a capital gain is the appreciation between the original cost and current sale price. The federal government and most state governments tax this "gain" if the asset is sold.
The sales procedures less any associated selling costs represent the "value" of the property being sold. It does not matter if the property is encumbered by debt or not in this calculation. And, it does not matter if all proceeds are received at the time of sale or not. The net result is still the value of the property at the time of sale – the top number in our simple mathematical equation to determine the amount of "gain" in the property.
In contrast, cost basis is the bottom number that is subtracted from value to give us the answer to our gain question. Simply stated, cost basis is the original cost of the property, plus any improvements made by the owner. Improvements can be items such as:
- Installing utilities on a building lot (electrical pole, well, septic system, etc)
- New roof or deck
- Remodeling the interior of the home
- Numerous other improvements performed by the owner
When selling property, it is imperative to define the cost basis of the investment. Accuracyely define any improvements made on the property and compare it to the current value. The difference is the capital gain and subsequent amount that could have been taxed by the government during the sale. By having developed an accurate cost basis, you will be better prepared to take advantage of the various capital gain tax planning options.