How to Calculate Cost Basis on the Sale of Rental Property

Understanding the cost basis and how to calculate it is important for rental real estate investors. Your cost basis on a property determines how much taxable profit you make when selling, which can directly affect your tax liability. Calculating the cost basis starts with figuring out what the cost was to acquire your property, though this may be adjusted to account for improvements and depreciation.

A financial advisor can help you determine your cost basis on a rental real estate investment.

Understanding the Basics of Cost Basis

The cost basis of an asset, such as a rental real estate property, refers to the original value of an asset as calculated for tax purposes. For many assets, like stocks, the cost basis is simply what it cost to buy the asset. But when applied to rental restate, the cost basis can differ from the acquisition cost because of adjustments made to account for factors like improvements and depreciation.

Understanding how to calculate your cost basis is central to understanding your potential tax liability. When you sell a property, the cost basis is used to calculate capital gains tax a tax that applies to profits made from selling assets.The taxable gain on an asset sale is calculated by subtracting the cost basis from the sale price of the asset.

Calculating Cost Basis

Figuring out your cost basis can be complicated, but in many cases, its straightforward. In the simplest of examples, if an investor purchased a rental property for $300,000, that purchase price would be the cost basis. So if the investor sold the property for $350,000, they would have a $50,000 gain that capital gains taxes would apply to.

However, that is a very simple example. In many cases, the cost basis is adjusted upward or downward based on a few different factors.

Increases to Cost Basis

Closeup of a handshake representing a real estate deal.

One way the cost basis of your property can increase is through improvements and additions. For example, if the above investor spends $20,000 on a new roof, this expenditure would increase the cost basis to $320,000. Now, if the investor sells for $350,000, the taxable gain would only be $30,000.

Not all rental expenses increase cost basis, though. For example, spending money to have a plumber unclog a stopped-up drain wouldn’t increase the cost basis. A new roof isn’t a similarly routine repair or maintenance but rather a significant improvement that adds to the property’s value, which is why it would increase the cost basis. Renovating the kitchen is another example of an improvement that could adjust the cost basis upward.

Decreases to Cost Basis

The cost basis can also decrease. Depreciation is a common way for cost basis to decrease. An investor who owns rental property can deduct a certain amount for depreciation each year on their taxes. When the investor deducts depreciation, it increases the cost basis by the same amount.

For example, an investor who takes $5,000 a year for depreciation over 10 years would deduct $50,000 overall. This amount would be subtracted from the cost basis. Using the same initial cost basis as above, after accounting for depreciation, the adjusted cost basis would be calculated as follows:

$300,000 (purchase price) + $20,000 (cost of the new roof) – $50,000 (depreciation) = $280,000 cost basis

Cost Basis and Capital Gains

When selling the rental property, the investor will subtract the adjusted cost basis from the sale price to determine the capital gain. If the property sells for $350,000, the capital gain would be determined by taking the sale price and subtracting the adjusted cost basis, as seen in this example:

$350,000 (sale price) – $280,000 (adjusted cost basis) = $70,000

In this example, the $70,000 is the capital gain used in calculating capital gains tax.

How to Track and Document Cost Basis Adjustments

Accurately maintaining cost basis records is essential for real estate investors to minimize capital gains taxes and stay compliant with IRS reporting requirements. Each adjustment to your property’s basis—whether from capital improvements or depreciation—must be documented and supported with clear records.

For capital improvements, retain all receipts, invoices, contracts and permits that verify the work completed. The IRS requires that improvements are permanent and add value to the property or extend its useful life. Examples include roof replacements, HVAC upgrades, major renovations or structural additions. Clearly separating these improvements from routine repairs helps ensure that only qualified expenses are used to increase basis.

Depreciation should be recorded annually as part of your tax return, typically on IRS Form 4562. Keep copies of each year’s return showing the depreciation deduction, along with your original depreciation schedule. These records demonstrate the reduction in basis over time and are necessary if the IRS audits the sale of your property.

If you refinance, subdivide or exchange properties, additional basis adjustments may apply. For instance, a 1031 exchange can defer capital gains taxes, but basis carries over to the new property. Mortgage-related fees like points may or may not affect basis, depending on how they are treated for tax purposes.

Plan to organize all documentation by year and transaction type. Using a spreadsheet or dedicated software can simplify the tracking process and help calculate the current adjusted basis at any time. When preparing for a sale, having a complete cost basis history allows for accurate reporting of gains, and minimized risk of IRS penalties It also helps your tax professional optimize your outcome.

Bottom Line

A homeowner signing documents for a rental property.

Understanding and accurately calculating your cost basis is a vital part of real estate investing. It helps an investor understand the potential profit from a sale as well as tax liabilities. When selling property, subtract the cost basis from the sale price to determine the amount of capital gains on which you will owe taxes. The cost basis starts with the purchase price of a property and is adjusted for improvements and depreciation over time.

Tips for Tax Planning

Tax laws are complex and changing, so it’s a good idea to consult with a financial advisor when dealing with these issues. Finding a financial advisor doesn’t need to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s free online Capital Gains Tax Calculator will help you see how much tax you’ll owe when selling rental real estate or other investment assets.