Calculating the correct tax basis for your commercial income property is essential for avoiding higher capital gains taxes when a property is sold. However, many investors don’t realize that determining tax basis is also important before you sell a property since a property’s tax basis also plays a role in determining depreciation.
The IRS allows commercial real estate investors to deduct depreciation from a commercial real estate building (as well as any capital improvements made). The IRS does not include land as a depreciable asset. While there are initial benefits from deducting depreciation while you own an investment property, this results in higher capital gains taxes when the property is sold, since this part of your capital gains is in higher rate taxes.
What Is Tax Basis?
Basis is the cost of the property paid in cash, debt obligations, or other property. It is determined by adding settlement and closing costs to the purchase price of the property.
According to the IRS, these settlement costs can be included when calculating tax basis:
- Abstract fees (abstract of title fees)
- Charges for installing utility services
- Legal fees (including title search and preparation of the sales contract and deed)
- Recording Fees
- Transfer taxes
- Owner’s title insurance
- Any amount the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
The following costs cannot be included when calculating tax basis:
- Casualty insurance premiums
- Rent for occupancy of the property before closing
- Charges for utilities or other services related to occupancy of the property before closing
- Charges connected with getting a loan. The following are examples of these charges:
- Points (discount points, loan origination fees)
- Mortgage insurance premiums
- Loan assumption fees
- Cost of a credit report
- Fees for an appraisal required by a lender
- Fees for refinancing a mortgage.
The basis of your investment property can either go up or down, depending on various factors. Thus capital improvements increase the basis, while depreciation decreases the cost basis.
Without proper planning, you will end up paying double taxes:
- Once on the adjusted basis minus the depreciation claimed while you owned the property, and
- A second time for the 25% depreciation recapture tax, which is the difference between the property’s depreciated value and its adjusted basis.
1031 Exchanges And Tax Basis
The benefit of 1031 exchanges is clear here, as it allows you to defer capital gains taxes and federal and state income taxes through a properly structured exchange. Capital gains taxes range from 15% – 23.8%, depending on your tax bracket.
When a 1031 exchange is carried out, the basis of the old property is transferred to the new property. For example, if the original property was sold for $2,500,000 with an adjusted cost basis of $750,000, then $750,000 would be carried forward to the new property.
If the purchase price of the replacement property was $3,000,000, then your adjusted basis would now be the original cost basis ($750,000) plus the difference in price between the original property and the replacement property ($500,000).
The new cost basis is now 1,250,000, and is referred to as “boot.”
Cost Basis Calculation
- First, calculate all of the closing costs related to the purchase of the investment property. Then add that number to the original purchase price.
- Next, you need to deduct any lender fees, points, loan assumption fees or mortgage insurance premiums from the above number, since the IRS does not allow them to be included as settlement costs when determining cost basis.
- Then, calculate the amount spent on capital improvements.
According to the IRS, capital improvements improve the value of the property and include:
- Changing a property’s use to a different use
- Adding on to the property
- Re-building a property that has already “met its useful life.”
- Replacing a major part of the property
- A repair that creates an increase in efficiency, productivity, or capacity
- Fixing a defect or design flaw
Examples of capital improvements include replacing a roof or HVAC system, adding on a wing or extending a portion of the property, or extensive interior renovations that allow you to add more tenants or increase space within a commercial property.
- Finally, deduct the amount of depreciation that was claimed on the income property.
This final amount is now your adjusted cost basis.
Please take notes, and make sure to keep all documents that pertain to repairs, improvements, or replacements, and use these documents to calculate depreciation and cost basis on a yearly basis. However, since determining which expenses count as capital repairs can be complex, it may be best to consult your accountant or an experienced broker.
To Wrap It Up
You should be very careful when calculating the cost basis, no matter if you sell or discard the real estate property. A proper calculation will provide you the best available options.
It is very important to adjust the cost basis of the property. If the cost basis is lower, when selling or foreclosing the property, you will consequently have to pay higher capital tax gains. In case of a sale, you will have to be very mindful on planning the recapture taxes.
For example, if the value of the sold property is higher than its depreciated value, you will have to pay further depreciation recapture taxes (which is 25%, a bit higher than the usual capital gains tax which is 15-23.8%).
Westwood Net Lease Advisors are here if you need any consultation or advice
We can provide you information about all your concerns regarding tax liabilities. We will help you determine the tax history of the desired property as well, and guide you throughout any future property tax costs.
1031 exchange, capital gain taxes, commercial real estate, commercial real estate investors, cost basis, Depreciation, IRS, taxes