In real estate, “basis” is essentially the value of the property for tax purposes. Basis is determined by the method in which the property is acquired. These methods are:
- Purchase – basis equals the total purchase price of the property plus any capitalized acquisition costs (not financing costs)
- Inheritance – basis equals the market value of the property at the time of the decedent’s death (regardless of decedent’s basis)
- Gift – basis equals the donor’s basis plus any adjustment made for taxes
- Tax-deferred exchange – substitute basis must be calculated to track the non-recognition of gain as a result of the exchange
The basis calculated using these various methods is referred to as original or acquisition basis. For the most common acquisition method (purchase), original basis is calculated by taking the purchase price and adding acquisition costs.
- Property Assumptions
- Purchase price: $1,000,000
- Acquisition costs: $50,000
- Original (Acquisition) Basis: $1,000,000 + $50,000 = $1,050,000
Basis is used to determine cost recovery deductions, gain or loss at the time of sale, and amortization deductions. Basis may change over time and can increase or decrease over the holding period of an investment. The most common cause for decreases in basis is due to cost recovery deductions (depreciation) while the most common cause for increases in basis is making capital improvements to a property.
Basis is an important concept for real estate investors and owners to understand. It determines the amount of cost recovery deductions that can be taken which lowers taxable income thereby increasing cash flow after taxes. It also determines the potential gain or loss at the time of disposition which directly impacts the sales proceeds after taxes. Aptly named it forms the basis on which a property’s investment value can be calculated.