When it comes to managing your finances and investments, understanding how to calculate the basis of real property is crucial. The basis of real property is a key concept in determining your gain or loss when you sell the property, as well as in calculating depreciation for rental property. In this blog post, we’ll break down what real property is according to the IRS and provide a step-by-step guide on how to calculate its basis.

What is Real Property According to the IRS?

Real property, as defined by the IRS, includes land and any permanent structures or improvements attached to the land. This encompasses:

(a) Residential homes

(b) Commercial buildings

(c) Rental properties

(d) Land

(e) Improvements such as landscaping, fencing, and buildings

Real property is distinct from personal property, which includes movable items like vehicles, furniture, and equipment.

Understanding the Basis of Real Property

The basis of your real property is essentially the amount of your investment in the property for tax purposes. It’s used to calculate depreciation, amortization, and depletion, and to determine your gain or loss when you sell the property.

Steps to Calculate the Basis of Real Property

1. Initial Purchase Price

The starting point for determining the basis of real property is the initial purchase price. This includes:

(a) The cost of the property itself

(b) Any expenses associated with the purchase, such as closing costs, legal fees, title insurance, and transfer taxes

Example: If you purchased a property for $250,000 and paid $5,000 in closing costs, your initial basis would be $255,000.

2. Adjustments to the Basis

Over time, you may need to adjust the basis of your property. Adjustments can increase or decrease your basis and are typically the result of:

(A) Improvements: Permanent improvements that add value, prolong the life of the property, or adapt it to new uses increase your basis. Examples include adding a new room, upgrading the plumbing, or installing a new roof.

(B) Depreciation: If you use your property for rental purposes, you can depreciate the cost over time, which decreases your basis.

(C) Casualty Losses: Damage to your property from events such as fires or floods that are not fully covered by insurance can decrease your basis.

(D) Insurance Reimbursements: Any insurance reimbursements for casualty losses or for improvements will adjust your basis accordingly.

Example: If you spent $20,000 on a new roof and $10,000 on landscaping, your adjusted basis would increase to $285,000 ($255,000 initial basis + $30,000 improvements).

3. Calculating Depreciation

For rental properties, depreciation is an important factor. The IRS allows you to depreciate the value of the property (excluding land) over 27.5 years for residential rental property and 39 years for commercial property.

Example: If your building (excluding land) is valued at $200,000, the annual depreciation for a residential rental property would be approximately $7,273 ($200,000 / 27.5).

4. Selling the Property

When you sell the property, your gain or loss is determined by the difference between the selling price and your adjusted basis.

Example: If you sell the property for $350,000 and your adjusted basis is $285,000, your gain would be $65,000 ($350,000 – $285,000).

Conclusion

Understanding how to calculate the basis of real property is essential for accurate tax reporting and financial planning. By keeping detailed records of your purchase costs, improvements, and depreciation, you can ensure that you correctly calculate your basis and determine your gain or loss upon sale. Always consult with a tax professional or accountant to ensure compliance with IRS regulations and to optimize your tax situation.

By mastering these concepts, you’ll be better prepared to manage your real property investments and make informed financial decisions.