As a real estate investor, there is much you need to know to make savvy decisions. One big issue that often seems to intimidate investors is the idea of “basis.” Fortunately, basis is a straightforward concept and understanding how it is calculated and why it’s important will help you as you strive to make informed decisions about your investment options.
What is Basis?
Basis is the amount of your capital investment in a property for tax purposes—essentially its cost to you. The cost is the amount you pay for it in cash, debt obligations, and other property or services. Cost includes sales tax and other expenses connected with the purchase. Most of these costs are listed on the closing statement you receive after escrow when the property closes. However, some may not be listed there, so consult your records to see if you’ve made other payments that should be added to your property’s basis. These payments include real estate taxes owed by the seller that you pay, settlement fees, and other costs such as title insurance.
Before figuring gain or loss on a sale, exchange, or other disposition of property, or before figuring allowable depreciation, you must determine your adjusted basis in that property, because basis can change over time. Your basis increases with the cost of improvements that add to the value of the property, and it decreases by items such as allowable depreciation and insurance reimbursements for casualty and theft losses.
Basis is used to determine depreciation, amortization, depletion, casualty losses, and any gain or loss on the sale, exchange, or other disposition of the property. For investors this matters because when you sell your multifamily or commercial property, your gain or loss for tax purposes is determined by subtracting its basis on the date of sale from the sales price (plus sales expenses, such as real estate commissions). The larger your basis, the smaller your profit will be, which reduces your tax liability. If the property sells for less than its basis, then you have a loss.
Why is Understanding Basis Critical to Real Estate Investing?
As you can see, understanding your basis is critical as you seek to make real estate investment decisions. When people call me seeking to do a 1031 exchange, I ask two questions up front: (1) What is your basis in the property? (2) What will be your tax consequence if you do not complete the 1031 exchange?
The good news is that basis is an easy calculation for your CPA or accountant, and it’s a question they will usually answer via a quick phone call or by email. If you’re considering a 1031 exchange and you don’t know your basis, don’t hesitate to contact your accountant. This is in their wheelhouse and it’s a question they are prepared to answer.
When investing in real estate, you need a trusted advisor you can count on. For expert real estate investment advise call René Nelson, CCIM CRE, 541-912-6583.