Cost Basis

Cost basis is what you have invested in a rental property for tax purposes: the purchase price, plus the closing costs you paid to acquire it, plus the capital improvements you make over the years. It is the number two of the biggest figures on your return are built from, your annual depreciation deduction and your taxable gain when you sell.

Basis is not static. The starting figure is your original basis, but it changes as you add improvements and subtract the depreciation you take each year. The running figure is called adjusted basis, and it is the one the IRS cares about on the day you sell.

In practice

Say you buy a duplex for $340,000 and pay $9,000 in closing costs that are added to basis (title fees, transfer taxes, recording fees, owner's title insurance). Your original cost basis is $349,000. Loan points and prepaid interest do not go here; they follow their own rules.

Only the building depreciates, not the land, so you split that $349,000. If the county assessor allocates 20% to land, then $69,800 is land and $279,200 is the building. That $279,200 is the basis you depreciate straight-line over 27.5 years, roughly $10,153 a year once the property is fully in service. After five years you would have taken about $50,764 in depreciation.

Now add a $24,000 roof replacement in year three. That is a capital improvement, so it raises basis rather than being expensed. Five years in, your adjusted basis is $349,000 plus $24,000 minus $50,764, which is $322,236. If you sell for $430,000 that year, your gain is measured against $322,236, not the $349,000 you started with. The depreciation you claimed comes back as depreciation recapture, taxed at its own rate.

Why it matters to a small landlord

Basis is where a clean paper trail pays you back. Every closing-cost line you correctly fold in, and every improvement receipt you keep, lowers your taxable gain later and supports the depreciation you take now. Miss the land split and you either overstate depreciation (a recapture problem at sale) or leave money on the table every year. For the mechanics of that annual deduction, see rental property depreciation, and run the numbers in the depreciation calculator before you commit a figure to your return.

Basis touches several other terms worth knowing: closing costs decide what gets added at purchase, a capital improvement raises basis while a repair does not, and depreciation recapturesettles the bill for the deductions basis fed you along the way. Track all three from day one and the gain calculation writes itself when you sell.