Adjusted Basis

The number the tax is measured from

Ask an owner what they will owe when they sell, and most start with the price. The law starts with something else.

Gain on a sale is the amount realized minus your adjusted basis (§1001). "Adjusted basis" is your original cost (§1012), adjusted over the years you owned the property (§1016). So the figure your exit is measured from is not the price you paid and not the price you get — it is a running number that has been moving the entire time you held the property.

That makes basis one side of the calculation, and it is the side your records have to back up. The other side is the amount realized: broadly, what the property sells for, less the costs of selling it. That side is settled on the day you sell. Paying your loan off out of the proceeds does not reduce it: that changes the cash you walk away with, not the amount you are treated as realizing. Notice which side depends on a history you need to have documented before the sale.

Get the basis right and every later calculation about your exit has a solid starting point: your gain, the character of that gain (how it is classified for tax, which decides how it is taxed), and what an exchange defers. Lose track of it and every one of those is a guess. Basis first.

This is educational information about how basis works, not individualized tax advice. Your actual basis depends on your facts and the applicable rules; what you can substantiate depends on your records. Confirm it with your own qualified tax professional.

Where the ledger starts: your cost

Basis begins as what the property cost you — and that is usually more than the contract price.

Under §1012, basis is your cost. For real property, certain acquisition costs are capitalized, meaning added to basis along with the purchase price. Note the word certain: not every line on your settlement statement (the closing document that itemizes what was paid) belongs there.

Costs of acquiring the asset generally go in — title and abstract fees, legal and recording fees, surveys, transfer taxes, owner's title insurance. Costs of getting the loan generally do not — origination fees and points (interest paid up front to the lender), the lender's appraisal, credit-report fees. Other items, like casualty insurance or rent for occupying the property before closing, are handled under their own rules rather than added to basis.

The practical point is that your starting basis is usually higher than the number on the purchase contract. These costs are the cheapest addition to basis you will ever make, and the easiest to lose, because the only time they are easy to capture is at closing, while the settlement statement is in front of you. Which specific items qualify depends on your facts and the rules. IRS Pub. 551 carries the working list, and your tax professional applies it to your statement.

On the example rental these guides use — a $280,000 long-term rental, an illustration rather than a forecast, whose full assumption set is listed in The Operating-Expense Build & the 50% Rule — the worked model treats its $5,000 of closing costs as cash to close and, as a simplification, adds none of it to basis, so its cost basis is the price itself, and $224,000 of that is allocated to the building. The building's share is what depreciation runs on. On a real settlement statement, the costs that belong in basis would be added in, raising the total and the building's share with it. The land portion is not depreciated, and how that split is made is covered below.

How the ledger moves while you own it

Once set, basis does not sit still. Two forces move it (§1016(a)).

Up, for capital improvements. Costs that improve the property — an addition, a roof replacement, a major system replacement, a substantial renovation — generally increase basis (§1016(a)(1)). Routine repairs and maintenance generally do not. Those are current deductions, written off as expenses rather than added to basis. Exactly where that line falls depends on the facts and has its own body of rules. Keeping a record of which side each cost fell on, year after year, is a bookkeeping discipline. It is the difference between a basis you can prove and one you can only estimate.

Down, for depreciation. The building is depreciated over the years you own it, and that depreciation reduces basis (§1016(a)(2)). This is the rule to remember, because it is what drives the ledger down: adjusted basis generally must reflect depreciation allowed or allowable. That means basis is reduced by the depreciation you were entitled to take, whether or not you actually claimed it.

Read that twice, because it is the one place where doing nothing costs you twice. Not claiming depreciation does not generally preserve a higher basis, because the reduction applies either way. So claiming less depreciation than you are entitled to leaves the eventual gain where it would have been anyway, and gives up the deduction unless it is later corrected — which is the subject of Depreciation you missed, below. On the example rental, the first year's depreciation is $7,806, and that is the first entry on the downward side of the ledger.

What you depreciate and the recovery period are the depreciation guide's territory. Two points the ledger depends on are stated here, because no other guide covers them. The land-and-building split allocates your cost basis between the two by their fair market values when you bought; if those are uncertain, the ratio in the local property-tax assessment is a common basis. Only the building share is depreciated. Depreciation you missed is not generally fixed by simply claiming it late. If only one return omitted it, an amended return may correct it; once the same incorrect method has been used on two or more consecutive returns, the fix is generally a change in accounting method on Form 3115, which your tax professional files.

Adjusted basis is not your equity

Four numbers describe one property. They are easy to confuse, but none of them is the same as another. If you have just been reading about how a rental builds wealth, the one most likely to blur with adjusted basis is equity.

Adjusted basis is not your equity. Equity is a financial position: what would be yours if the property sold at today's value and the loan were repaid. Adjusted basis is a tax accounting figure: the running record of what you put into the property, less what has been depreciated out of it. Two of these numbers move with the market, and two are not affected by it at all.

They can drift very far apart. Pay the loan down and equity rises while basis does not move. If the market rises, value and equity rise while basis does not move. Depreciate the building for a decade and basis falls while nothing about your equity changes. A property can hold substantial equity and a low basis at the same time — and that combination is exactly the one that produces a larger tax bill at sale than the owner expected.

What the ledger is for

All of that record-keeping exists to produce one number at one moment.

When you dispose of the property, the law measures gain as the amount realized minus your adjusted basis (§1001). For that purpose it points explicitly at basis "adjusted as provided in §1016" (§1011). So the figure you have been raising and reducing while you owned the property is the figure the exit is measured from. The shorthand:

Cost, including capitalizable acquisition costs · plus capital improvements · minus depreciation allowed or allowable ≈ adjusted basis

Keep that as a mental model rather than a legal formula. Real returns can involve other adjustments that sit outside the shorthand, such as casualty losses, certain credits and partial dispositions (disposing of part of the property rather than all of it). What matters is the shape: your gain is generally the amount realized minus your adjusted basis, not what it sold for minus what I paid. And because depreciation has been quietly lowering basis the whole time, the gain is usually larger than the "how much did it go up" figure an owner carries in their head.

This page deliberately stops before computing that number for the example rental, because a defensible adjusted basis at any given year is the sum of a whole history of ownership: every improvement and every year's depreciation. Inventing one to make an example tidy would teach the arithmetic while misrepresenting the input.

The ledger is built during the hold

Your adjusted basis is determined by the facts and the tax rules. But at the exit you need records that back up the figure you use: acquisition costs captured at purchase, every capital improvement recorded and kept separate from repairs, and depreciation taken correctly year after year.

The owner who can hand over a clean basis schedule at closing, a record of the starting cost and every adjustment since, has options. The owner reconstructing a decade of capital improvements from memory and a folder of receipts overpays, or panics, or both. The figure you can defend is only as good as the records behind it — which is why basis is a bookkeeping discipline carried out while you own the property, not a task that begins the week you decide to sell.

Where basis carries, and where it resets

Basis also explains how a property can change hands without triggering tax — or with the tax permanently cleared. This page names the patterns and stops; each has its own guide.

• It carries in a like-kind exchange. In a like-kind exchange, you dispose of the property and acquire replacement real property under the exchange rules without recognizing some or all of the gain, meaning without being taxed on it now. Roll into a replacement property this way and your old adjusted basis generally carries into the new one (§1031(d)), so the deferred gain stays in that low carried-over basis until a later taxable sale. That is the mechanical reason deferral is not forgiveness: the gain moved into the next property's basis rather than disappearing.
• It can reset at transfer. For property acquired from someone who has died, basis is generally adjusted to fair market value at death (§1014). That is usually called a step-up, though the adjustment can also be downward if value has fallen. For property acquired by gift, the recipient generally takes a carryover basis for determining gain (§1015), meaning the giver's basis carries over, subject to special rules.

Both are their own subjects. They are named here only so you can see that basis is the common thread through every way a property moves.