When you sell a property at a profit, you have to pay capital gains taxes on the sale. However, your capital gain isn’t the difference between the price you paid for the property and the price you sell it for. There are several other expenses that add to your cost basis.
Knowing what expenses can and cannot be added to your cost basis helps you accurately calculate your capital gain on a real estate sale. And it can save you significant money on your taxes over the long run. Here’s a quick guide to calculating your cost basis, what improvement expenses are included, what you can’t include, and why it matters so much.
What is your cost basis?
First, it’s important to know your cost basis when acquiring a property. This will be important in determining (and reducing) any capital gains tax you owe when you sell the property.
Your cost basis obviously includes the price you agree to pay for the property. It also includes certain settlement costs, such as:
- title fees,
- legal fees,
- recording fees,
- survey fees, and
- any transfer or stamp taxes you pay in connection with the purchase.
However, your cost basis does not include hazard insurance premiums, moving expenses, or any mortgage-related charges. So mortgage insurance, credit report fees, and appraisal costs are out.
You want your adjusted cost basis to include as many of your property-related expenses as possible. A higher cost basis translates to lower tax liability later on.
For example, if you buy an investment property for $200,000 and sell it for $300,000, it may sound like you have a $100,000 capital gain. However, if you spend $5,000 on acquisition costs and $25,000 on renovations, your cost basis will be $230,000, which lowers your taxable gain to $70,000.
Home improvements that add to your cost basis
Besides purchase cost, the other big component of cost basis is the improvements you make to the property. These can be made immediately upon acquisition of the property or at a later date.
The IRS defines improvements as expenses that add to the value of the property, prolong its useful life, or adapt it to new uses. There’s obviously some gray area here. But examples will help clear it up a bit.
Basis-increasing improvements can include the following:
- Additions: If you add an extra bedroom or bathroom, put a deck on the back of the home, add a garage, or construct a porch or patio, you've added value to the home.
- Lawn and grounds improvements: Value-adding landscaping projects, driveway or walkway construction, building a fence or retaining wall, and adding a swimming pool can qualify as property improvements.
- Exterior improvements: New windows, a new roof, and new siding are examples.
- Insulation: This includes insulation in the attic, inside walls, under floors, or around pipes and ductwork.
- Systems: Installing a new heating or air conditioning system, new ductwork, adding a central vacuuming system, wiring improvements, installing a security system, and putting in lawn irrigation are improvements.
- Plumbing: Installing a septic system, water heater, or soft water system adds value.
- Interior improvements: New appliances certainly increase the value and extend the useful life of the property, as do kitchen renovations, new flooring/carpeting, and the installation of a fireplace.
This isn’t an exhaustive list.
It’s also worth mentioning that while general repairs aren’t part of a property’s cost basis, they can be included if they’re done as part of a qualified improvement project. For example, repairing small holes in your walls isn't an improvement. But if it’s done as part of a large-scale kitchen renovation, you could add it to your basis as part of the overall improvement project.
Example of adjusted cost basis
Here’s a simplified example to illustrate how this might work. Let’s say you bought your home in 2000 for $150,000 and that you paid $3,000 in various acquisition expenses. Over the years, you had the following expenses:
- 2005: You bought a new water heater for $500, including installation costs.
- 2007: You renovated your master bathroom for $10,000.
- 2010: You spent $2,000 on general home repairs.
- 2012: You renovated the kitchen for $20,000.
- 2015: You replaced the central air conditioning for $5,000.
Let’s say you sell the property in 2019. Your cost basis includes the property’s purchase price and acquisition expenses plus most of the expenses on this list. The $2,000 for general home repairs isn't added to the cost basis (though it could still be tax deductible if this is an investment property).
Adding up the other expenses and the purchase price gives you a cost basis of $188,500. This is the number used to determine if you owe any capital gains taxes on the sale.
To reiterate, this is a simplified example. Over the course of a nearly 20-year ownership period, you might have a much longer list of improvements. So it’s important to keep track in order to keep your cost basis as high as legally possible.
What improvements don’t add to cost basis
Generally speaking, an expense isn't added to your cost basis if it doesn’t add value to the property, prolong its life, or change its usable purpose (such as converting from a single-family home to a duplex).
In practice, this means you can’t add the costs of general repairs or maintenance. You might argue that fixing plumbing leaks and similar repairs increase the market value of your property. But the difference is that these expenses are necessary to keep the property in good working order.
Here's an example. If your refrigerator motor breaks, calling a repairman to fix the problem is necessary to keep the home in usable condition. Buying a new refrigerator when the old one is repairable is an optional expense that goes above and beyond what’s necessary -- and it adds value to the home.
Furthermore, you can’t add any improvements with a life expectancy of less than one year to your cost basis. This can be a helpful piece of guidance, especially when it comes to landscaping improvements. For example, adding palm trees to your yard could be a basis-increasing improvement. Adding annual flowers that need replacing the following year would not qualify.
Finally, you can’t add improvements to your basis if they're no longer part of your home. Let’s say you bought your home in 2000, bought a new refrigerator for $800 in 2005, and replaced it with another new refrigerator for $1,200 in 2015. The cost of the 2005 refrigerator wouldn’t be included if it’s no longer in the home after you buy a replacement.
Don’t get this wrong
Here’s why this is so important. When you sell a property, the difference between the net sale proceeds and your cost basis is a capital gain and could be subject to tax.
With a primary residence, there’s a capital gains exclusion of $500,000 for married couples and $250,000 for everyone else. Other type of real estate, such as a second home or investment property, have no such exclusion.
Continuing our earlier example, let’s say that the property you bought in 2000 that has a cost basis of $188,500 is sold in 2019 for $420,000 and that you’re single. Even though the sale price is $270,000 more than you paid for the home, it’s only $231,500 more than your cost basis, so it wouldn’t trigger a taxable event.
With investment properties, you get the added benefit of increasing your annual depreciation deduction. You can read more about how depreciation works, but the general idea is that you can deduct a certain portion of your cost basis each year to reduce your taxable rental income. A higher cost basis means higher annual depreciation deductions.
The bottom line is that the accurate calculation of your cost basis in a property can help you lower your capital gains tax liability upon the sale of a property. It can also potentially lower your taxable rental income on investment real estate. So be sure to add the cost of property improvements to your cost basis as you go.