How to Calculate Cost Basis for Primary Residence Turned Rental?
In this article, we’ll explain how to calculate the cost basis for a primary residence that has been converted into a rental property. We’ll cover what cost basis is, why it’s important for tax purposes, and provide a step-by-step guide to determining your adjusted cost basis, including depreciation considerations and improvements.
Contents
- What Is Cost Basis?
- Step-by-Step Guide to Calculating Cost Basis
- Why Is Calculating Cost Basis Important?
When converting a primary residence into a rental property, calculating the cost basis is an essential step for tax purposes. The cost basis determines how much depreciation you can claim during the rental period and helps calculate your capital gains or losses when you sell the property. This process involves understanding the original purchase price, fair market value (FMV) at the time of conversion, and adjustments for improvements or depreciation. In this article, we’ll provide a detailed guide to help you calculate the cost basis for a primary residence turned rental, including formulas presented in easy-to-read tables.
What Is Cost Basis?
The cost basis of a property is the starting value used to determine taxable gains or losses when selling an asset or claiming depreciation. For a home converted into a rental property, the IRS requires you to use the lower of:
- The original cost basis, which includes the purchase price and certain costs or improvements.
- The fair market value (FMV) at the time of conversion.
This ensures that depreciation and capital gains calculations are accurate and comply with IRS guidelines.
Step-by-Step Guide to Calculating Cost Basis
Step 1: Determine Your Original Cost Basis
Your original cost basis includes:
- Purchase price: The amount paid for your home.
- Closing costs: Fees such as title insurance, legal fees, and real estate agent commissions.
- Capital improvements: Renovations or additions that increase the value of your property (e.g., remodeling a kitchen or adding a deck).
Example Table: Original Cost Basis Calculation
| Item | Amount |
|---|---|
| Purchase Price | $250,000 |
| Closing Costs | $5,000 |
| Capital Improvements | $20,000 |
| Original Cost Basis | $275,000 |
Step 2: Determine Fair Market Value (FMV) at Conversion
The FMV is the property’s appraised value at the time it was converted into a rental. You can determine this through:
- A professional appraisal.
- Comparable sales in your neighborhood.
Example Table: Comparing Original Cost Basis and FMV
| Value Type | Amount |
|---|---|
| Original Cost Basis | $275,000 |
| FMV at Conversion | $260,000 |
| Lower Value to Use | $260,000 |
Step 3: Separate Land Value from Building Value
The IRS requires you to separate land and building values because land cannot be depreciated. Use your local property tax assessment or appraisal to determine this split.
Example Table: Land vs. Building Value
| Value Type | Amount |
|---|---|
| FMV at Conversion | $260,000 |
| Land Value | $60,000 |
| Building Value | $200,000 |
Step 4: Calculate Depreciable Basis
The depreciable basis is the portion of your cost basis allocated to the building (not land). This amount will be depreciated over 27.5 years for residential rental properties.
Formula for Depreciable Basis:
Depreciable Basis = Lower of Original Cost Basis or FMV – Land Value
Example Table: Depreciable Basis Calculation
| Calculation Step | Amount |
|---|---|
| Lower of Original Cost Basis or FMV | $260,000 |
| Subtract Land Value | -$60,000 |
| Depreciable Basis | $200,000 |
Formula for Annual Depreciation:
Annual Depreciation = Depreciable Basis ÷ 27.5
Example Table: Annual Depreciation Calculation
| Calculation Step | Amount |
|---|---|
| Depreciable Basis | $200,000 |
| Divided by 27.5 Years | ÷ 27.5 |
| Annual Depreciation | $7,273 |
Step 5: Adjust Cost Basis Over Time
Adjustments to your cost basis may occur due to:
- Improvements: Add capital improvements made after conversion.
- Depreciation: Subtract depreciation claimed during the rental period.
Formula for Adjusted Cost Basis:
Adjusted Cost Basis = Cost Basis at Conversion + Improvements – Depreciation
Example Table: Adjusted Cost Basis Calculation
| Adjustment Type | Amount |
|---|---|
| Cost Basis at Conversion | $260,000 |
| Add Improvements | +$10,000 |
| Subtract Depreciation | -$36,365 |
| Adjusted Cost Basis | $233,635 |
Why Is Calculating Cost Basis Important?
Accurate calculation of your cost basis ensures:
- Proper depreciation deductions during rental use.
- Correct reporting of capital gains or losses when selling.
- Compliance with IRS rules to avoid penalties or audits.
Failing to correctly calculate and adjust your cost basis could result in overpaying taxes or facing IRS scrutiny.
