When you own an investment property, understanding your cost basis is essential. Basis is the starting point for determining your taxable gain, how much depreciation you can take, and what your tax obligations will be when you sell. It also plays a critical role in tax-deferral strategies like a 1031 exchange, where knowing your adjusted basis helps you maximize the benefits and avoid costly mistakes.
By learning how to calculate your basis, you can make informed decisions about selling, reinvesting, and protecting your profits from unnecessary taxes.
Your basis in a property is one of the most important numbers in real estate investing. It plays a direct role in determining your tax liability and how much of your profit you get to keep when you eventually sell or exchange the property. A proper understanding of the basis can also help you make smarter investment decisions, plan for depreciation, and maximize the benefits of tax strategies like a 1031 exchange.
Your basis in a property determines:
- How much capital gains tax you will owe upon sale.
- How much depreciation you can take on your replacement property.
- What will be your new basis in your replacement property after a successful 1031 exchange.
- How aggressive can you be with cost segregation going forward.
What Is “Basis” in an Investment Property?
In short, the basis is the number the IRS uses to determine your taxable gain (or loss) when you sell your property. Think of it as your starting point for measuring profit. When you sell, the IRS will subtract your adjusted basis from the sales price to calculate how much you “gained.” That gain, after adjustments, is what you pay capital gains tax on.
Your basis also impacts other key areas of tax planning. For example, depreciation deductions—which allow you to recover part of the cost of your property each year—are calculated based on the basis. The higher your basis, the more depreciation you can claim. Conversely, the lower your adjusted basis becomes after years of depreciation, the larger your taxable gain will be when you eventually sell.
How to Find Your Cost Basis Using a Real-World Example
Let’s look at an example to make this more concrete.
John purchased a duplex in 2018 for $600,000. Over the years, his basis changed as follows:
- Purchase Price: $600,000
- Closing Costs: $10,000
- Capital Improvements (New Roof): $40,000
- Depreciation Taken From 2018–2024: $120,000
By 2025, John’s adjusted basis is $530,000.
Here’s how the math works:
- Start with the original purchase price of $600,000.
- Add allowable additions: closing costs ($10,000) and capital improvements ($40,000) → total of $650,000.
- Subtract depreciation taken ($120,000) → adjusted basis of $530,000.
This calculation illustrates how the basis evolves over time. It’s not just what you paid originally; it’s adjusted up or down based on improvements, expenses, and depreciation.
What Happens When John Sells in 2025?
Now imagine John decides to sell his duplex in 2025 for $975,000. Here’s how his gain would be calculated:
- Sales price: $975,000
- Less adjusted basis: $530,000
- Total gain: $445,000
That $445,000 is John’s taxable gain. But the IRS doesn’t treat all of it the same way.
- $325,000 is treated as capital gain (the difference between the sale price and basis, minus depreciation). Federal capital gains tax usually ranges from 15% to 20%, plus applicable state taxes.
- $120,000 represents depreciation recapture. The IRS requires you to “pay back” the tax benefit you claimed from depreciation deductions, and this is taxed at up to 25%.
Altogether, John could be facing a six-figure tax bill, potentially around $100,000 or more, depending on his tax bracket and state.
This is where planning becomes critical. If John pursues a 1031 exchange, he could defer both capital gains and depreciation recapture taxes by reinvesting the proceeds into another qualifying property. His basis would then carry over and be adjusted for the new property, allowing him to continue growing his portfolio without an immediate tax hit.
How a 1031 Exchange Can Help Investors
A 1031 exchange, also known as a like-kind exchange under Section 1031 of the Internal Revenue Code, allows real estate investors to sell a property and reinvest the proceeds into another qualifying property without immediately paying capital gains or depreciation recapture taxes. Instead of handing over a large portion of the profit to the IRS, investors can keep their equity working for them in a new investment.
The rules for 1031 exchanges are strict. For example, investors must:
- Identify potential replacement properties within 45 days of the sale.
- Close on the new property within 180 days.
- Use a qualified intermediary to handle the transaction.
- Reinvest all proceeds and maintain equal or greater debt to fully defer taxes.
For many investors, a 1031 exchange is a powerful tool to build wealth over time, but it requires careful planning and strict compliance with IRS guidelines.
Why Work With a Professional at 1031 Federal Exchange
Calculating basis, planning for depreciation, and structuring a 1031 exchange are complex tasks. Mistakes can cost investors thousands of dollars in unnecessary taxes. By working with experienced professionals who understand both real estate and tax law, you can ensure that your basis is calculated correctly, your exchange meets IRS requirements, and your tax burden is minimized.
Ready to Maximize Your Investment? Contact 1031 Federal Exchange to Learn More About Our 1031 Exchange Services in Ohio
If you are considering selling an investment property, planning a 1031 exchange, or simply need help understanding your cost basis, our team is here to guide you. Speak with 1031 Federal Exchange to learn more about our 1031 exchange services in Ohio. Call 513-488-1135 or contact us online for a free consultation. Located in Loveland, Ohio, we serve clients nationwide.