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.