What Is a Tax Basis? A Number Every Savvy Homeowner Needs To Know
Something about the word “tax” makes even the most ardent financial wizard’s eyes glaze over. We get it: It’s no fun to think about the money you have to hand over to Uncle Sam.
Yet, when it comes to real estate, understanding your tax basis is like knowing the rules of the game. Your tax basis is a fundamental factor that can significantly affect your finances when it comes time to sell your property.
However, tax basis is more important to some homeowners than others. Read on to find out everything you need to know.
What is a tax basis?
Tax basis, also known as cost basis, is a homeowner’s total investment in a property over time. In simple terms, tax basis is the value assigned to a property for tax purposes.
This number is essential to homeowners because it’s the starting point for calculating how much you’ll owe in taxes when you sell a property or make improvements.
Amanda Han, certified public accountant and managing director at Keystone CPA, explains that a home’s original purchase price is the initial tax basis, and over time, that number grows or shrinks.
So, what affects the tax basis?
Things like the cost of improvements, depreciation (for rental properties), and certain closing costs. While most closing costs are considered transaction expenses, costs related to permanent improvements made to the property at the time of purchase can be added to the tax basis.
For example, Han says that if someone buys a home for $200,000 and does a kitchen remodel for $30,000, the cost basis would total $230,000 plus any related closing costs.
Why sellers need to understand tax basis
Anyone looking to list their home should do a primer on tax basis because the number determines an owner’s gains and losses when a property is sold.
Basis is an essential figure if you’ve owned your home for a long time and have made drastic improvements to the property.
“I’ve had clients who didn’t consider their basis, and it did cause some issues during tax season,” explains Atiya S. Brown, certified public accountant and owner of The Savvy Accountant. “Some clients underestimated their basis, leading to higher capital gains and taxes when it came to selling their rental properties.”
What homeowners need to know
The good news for most homeowners is that basis “likely won’t make a big difference,” according to Brown, for the typical person selling their primary residence.
Why? As Brown points out, there is a hefty tax exemption in place that benefits most homeowners.
Namely, many owners do not pay capital gains taxes, depending on their tax filing status. Single homeowners are exempt for up to $250,000 in capital gains, while homeowners who are married and filing jointly don’t have to pay taxes on $500,000 of capital gains.
The importance of keeping records
While many homeowners won’t face a reckoning with their tax basis, you won’t know how significant that number will be until it comes time to sell.
So, keep meticulous records of home-related expenses and improvements to help you get a handle on your tax basis.
Han stresses the importance of keeping records as expenses occur because if you don’t, you might forget what improvements you made to your home over the years when it comes time to list your house.
Brown recommends a cloud-based receipt recording system for extra security to streamline the process. For those who don’t have accounting software, Brown suggests taking pictures of receipts and emailing them to yourself.
Which home improvement should you be tracking precisely?
Brown says that most homeowners know to include their kitchen or bathroom renovations. However, they may not consider the many other applicable improvements.
What real estate investors need to know
While the basis might not significantly affect the typical home seller, it can be a big deal for real estate investors as it can help them save on taxes after selling. On the other hand, underestimating one’s basis can lead to higher capital gains and taxes.
Cara Berkeley, a real estate investor and creator of the money blog “Penny Polly,” explains that basis “is a critical component” in her business.
“The higher your basis, the lower the gain,” she says.
“As someone who looks for great deals on undervalued properties, sometimes you end up with low-basis properties,” says Berkeley. “It is important to properly account for any improvements on the property since that increases your basis and ultimately reduces your tax liability.”
Han also notes that when it comes to investment properties, owners should take advantage of the depreciation tax break. This allows owners to spread out their deductions every year, which can offset the tax liability from their rental income.