Cost basis is a rather easy concept in investing. Your cost basis in an asset is the amount of money you paid to acquire it (with a few potential adjustments).
However, in real estate investing, cost basis can be more complicated. Especially when it comes to a 1031 exchange, a tool used by investment property owners to defer capital gains taxes. This is an important concept to know, as it determines the amount of capital gains tax you’ll have to pay.
What is cost basis in real estate?
When it comes to real estate investing, your cost basis is the price you pay to acquire a property, including any acquisition costs. For example, if you pay $200,000 for a property and pay $5,000 in legal expenses and lender fees, your cost basis is $205,000. That's true regardless of whether you pay in cash or with a mortgage.
It gets more complex with real estate investments because your cost basis can change over time. This is called adjusted basis. There are two common reasons for adjusting your basis in a property:
- You made a substantial capital improvement. For example, if you own an apartment building and renovate the kitchens in every unit, you could add that cost to your basis. If you own a single-family property, replacing the roof could increase your cost basis.
- You claim a depreciation expense. Investors can "expense" the cost of acquiring real estate over a certain number of years. This can dramatically lower an investor’s taxable income each year, but also reduces the adjusted basis in the property. This can lead to additional tax liability.
Why is cost basis different in a 1031 exchange?
I won't get into the specifics of how 1031 exchanges work, so if you’re interested, be sure to check out our 1031 exchange homepage. The basic idea is that a 1031 exchange lets an investor sell one property and reinvest the proceeds into another property. They then defer paying capital gains tax.
Since you're deferring the tax liability from one property to another, this affects the cost basis (for tax purposes) of the new property you acquire.
Calculating the basis of your new property
Your tax professional or 1031 exchange facilitator will probably calculate your new cost basis. Few investors have to calculate this figure on their own.
But if you're inclined to calculate your carried-over basis in your new property, here’s how to do it. The basic concept is that the cost basis in your new property is the cost of the new property minus any gain you deferred in the exchange.
The general formula for calculating cost basis of a new property
- Start with the adjusted basis in the property you sold, which includes any original mortgage you took out.
- Add the value of any other property you transfer in the exchange, the mortgage amount on your new property, the amount of cash you’re contributing to the new purchase, and any recognized gain on the sold property. (Note: Not all of these will apply to every 1031 exchange.)
- Subtract any money or property you received in the exchange, the amount of the mortgage on the sold property, and any recognized loss on any property sold in the exchange.
If you follow these three steps, you can calculate the basis of any property acquired as part of a 1031 exchange. One interesting takeaway is that the purchase price for the new property plays absolutely no role in determining its cost basis, which may be counterintuitive to investors.
For example, let’s say you perform a 1031 exchange by selling a property for $300,000. You have a mortgage of $150,000 on the property at the time of the sale, and your adjusted cost basis in the property is $170,000. You complete the exchange by purchasing a $500,000 property with a mortgage of $250,000.
In this case, you calculate your new basis by taking the original property’s adjusted basis ($170,000), adding your new mortgage ($250,000), and subtracting the original property’s outstanding mortgage ($150,000). This gives you a new basis of $270,000.
Fortunately, you don't need to memorize this formula. Because you'll probably be working with a qualified intermediary (QI), you'll have someone who's done this lots of times on hand. And if you don't, your tax professional can always help out.