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Which Home Improvements Add to Your Cost Basis?

Home improvementKnowing how to calculate your cost basis can save you money on real estate taxes.  Real Estate Investor Tip: 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. This 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
  • 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

Aside from 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.

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.

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