What is Tax Basis & How to Calculate It
When we meet with property owners about 1031 Exchange suitability, we find most owners have a good pulse on their tenants and the physical condition of the investment property. However, one factor that is often overlooked is an understanding of the tax basis and overall tax liability on the property they are intending to sell.
Understanding the potential tax consequences of selling investment property is a major piece of the puzzle. Taxes may seem overly complicated (they are) and inaccessible (they can be), but calculating an approximate tax basis is the first step in determining if a 1031 Exchange is an appropriate next step. With a few key pieces of information, property owners can quickly estimate the tax basis and overall capital gains on relinquished property.
What is Tax Basis in Real Estate?
In most situations, the basis of an asset is its cost. The term tax basis refers to the amount that will be subtracted from the eventual sales price of an investment property to determine the taxable gain. Basis is the term the tax law uses to refer to the amount of investment a taxpayer has invested in business assets. Generally, it equals the asset purchase price plus the cost of capital improvements minus any accumulated depreciation.
Several related terms, including cost basis, starting basis, and adjusted basis are also used in determining the worth of a property for tax purposes. Because basis changes over time, each of these terms represents the amount a property is worth at different periods of ownership.
Cost Basis or Starting Basis represents what you initially paid for the property, including closing costs. Cost basis is used as a starting point when the property was purchased and adjusted over the lifetime of owning the property. Capital gains represent the difference between the property’s adjusted cost basis and net selling price when the property is sold.
Adjusted Tax Basis
The Adjusted Tax Basis of the property you are selling is its adjusted cost basis to calculate capital gains. These adjustments typically include adding the cost of capital improvements and selling costs and subtracting depreciation costs previously taken as tax deductions. The higher your adjusted tax basis, the less you’ll pay in capital gains tax when you sell.
Calculating Tax Basis and Taxable Gains
Calculating the tax basis in your investment property begins with its original purchase price. The original cost is the amount actually paid at the closing, including closing costs. Add the cost of any capital improvements made to extend the value or useful life of the property. Then subtract the amount of depreciation claimed while owning the property. The balance equals your adjusted cost basis:
- Start with the original purchase price of the property
- Add the cost of major capital improvements
- Subtract the amount of allowable depreciation
- Subtract the amount of selling costs
- The balance equals your adjusted tax basis
Calculating Taxable Gains
To calculate taxable capital gains, deduct the “adjusted cost basis” of your investment property from the “net proceeds” received from the sale:
- Calculate net proceeds from property sale
- Subtract adjusted tax basis
- The balance equals taxable gains
Potential Capital Gains Tax
Property owners can pay up to 42.1% in taxes on the sale of their investment property depending upon the state the property is located and the amount of taxable gains. The applicable taxes are generally divided into two categories.
The first tax is the gain attributed to “Depreciation Recapture” – taxed at a current rate of 25%. The second is the gain attributed to appreciation beyond the original purchase price – taxed first at the owner’s “Long Term Capital Gains” bracket (currently either 15% or 20%) and possibly taxed at an additional 3.8% for the Net Investment Income Tax (also referred to as “Obamacare Tax”) depending on the owner’s investment income for the year.
Owners may have “Loss Carryforwards” that help mitigate these tax consequences. It is important to note that a sale of property can also impact other taxes such as the tax on the sale of stocks or bonds and the tax on ordinary income in the year of property sale.
Defer Capital Gains Tax With a 1031 Exchange
Knowing the tax basis of a property is an important step in assessing the tax-deferred 1031 Exchange options an owner has available to them. Owners with large tax liabilities should not feel limited if they want to transition their assets to take advantage of high valuations or lifestyle changes. Our 1031 Exchange Advisors develop strategies for property owners looking to unlock liquidity in their property and defer all their taxes.
To assist owners in understanding the tax piece, we have worked with one of our preferred CPA firms, Hutchinson & Walter, to create a simple and effective template for owners to arrive at their approximate tax liability. If you are interested in accessing this tool, please email firstname.lastname@example.org.
Austin Bowlin, CPA – Partner at Real Estate Transition Solutions, provides exit strategy analysis, execution, income and equity replacement options for investment property owners. If you have questions relating to your investment property ownership, you can email him at email@example.com or call (206) 686-2211.
The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsors Private Placement Memorandum (PPM) which is solely available to accredited investors and accredited entities. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million dollars exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity please verify with your CPA and Attorney. There are risks associated with investing in real estate and Delaware Statutory Trust (DST) properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee profits or guarantee protection against losses. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM.