Calculating Adjusted Cost Basis?

Question

I've searched the forums and haven't found any discussions that address a couple questions I have about calculating cost basis of a rental property.

1) I know that to determine cost basis, you need to multiply the purchase price of the house by the land/improvement ratio, which you can calculate based on your property tax assessment or the appraisal from when the house was purchased.  Would I use the property tax card from the year I bought my house (2015), the year I put it into service (2017), or the latest one (2018)?  Similarly, would using the 2015 appraisal be valid?

2) To calculate adjusted cost basis, it's necessary to add closing costs and costs of improvements and subtract agent rebates/seller credits.  But is this done on the original purchase price (before subtracting the land value) or on the cost basis (after multiplying the purchase price by the improvement ratio)?

Logan Allec · Answer

@Ed Shin

1) There's no "rule" per se concerning which property tax card to use (and I wouldn't imagine the land/improvement split changed much from year to year), so just go with the one when you bought the house if you're using this method to determine your land/building split.  That being said, using the assessor's split, while probably the easiest way to do it, is not the only way.  You can also use, say, replacement cost method, agreed-upon valuations, or comparable land sales (and these methods may allow you to allocate more to building), but whatever method you use has to be "reasonable" (vague, I know).

2) I would say (and some more aggressive types may disagree with me) that your closing costs, etc., were incurred just as much to purchase the building as they were to purchase the land, so I typically allocate them to land and building.

Michael Plaks · Answer

@Ed Shin

Hardly an issue of aggressive v. conservative.

There're two issues actually, and they should be considered separately. One is allocation to land. Once the entire adjusted basis is figured out, part of it should be allocated to land. Any reasonable method of allocation is acceptable, and people came up with many methods to do so. Some result in a bigger amount allocated to land, and some in a smaller amount. Depending on your circumstances, you may or may not want bigger depreciation.

The second issue is capitalizing v. expensing. Indeed, you cannot deduct anything until the property is placed in service. Even if an item would ordinarily be repairs - like repainting - it is still not deductible until the property is placed in service and should therefore be capitalized.

Then comes an exception per the Tangible Property Regs that allows de minimis expensing of items that would normally be capitalized and depreciated, as long as each item is under $2,500. Example: appliances and carpet.

Michael Plaks · Answer

@Ed Shin

1. You'd usually use the assessment from the year placed in service - 2017, in your case. It should make common sense, as you're allocating as of that date. That said, as @Logan Allec pointed out, you're allowed to use any reasonable method of allocation - and an assessment from a different year could be used, too, if you can show why it is more accurate than the one from 2017.

2. Not all closing costs are added to the basis. Some can be deductible (example: prorated property taxes), and others are considered costs of obtaining a loan (example: points and appraisal). Loan costs are separate from basis and are amortized, as opposed to depreciated.

Similarly, some improvements may be currently deductible and not added to the basis.

You normally calculate the adjusted tax basis first, and then you allocate part of it to land. What is left is properly referred to as "depreciable basis." Adjusted cost basis includes land, to keep the terminology straight.

Dave Toelkes · Answer

@Ed Shin

Your initial cost basis is simply what you paid for the property (including certain closing costs) minus any rebates or seller concessions plus the cost of any improvements you made before the property was placed in service.

I think you are really asking about something else, namely your depreciation basis for the dwelling structure.  Once you have determined your property's cost basis, the simplest approach to establishing the depreciation basis for the dwelling structure is to multiply your cost basis by your tax assessor's improvement ratio.

Ed Shin · Answer

@Michael Plaks

Thanks for your explanation.

Is my understanding correct that improvements made when the house is a personal residence - before it is converted into a rental and placed into service - can either be added to the cost basis of the house or be depreciated separately on their own schedules when placed into service on the same day as the house?

For example, 2 years before we placed our house into service, we installed a new patio and driveway and purchased a new fridge.  It would be more beneficial for us to depreciate these separately on their own schedules (15 years for the patio and driveway, 5 years for the fridge) than to add them to the cost basis.  We would need to depreciate them based on their current fair market value, right?  I understand we can determine the FMV of the fridge by searching for current prices of similar, used models, but how would we determine the FMV of the patio and driveway?  (I imagine the cost of replacing them would be comparable, if not more expensive, than what we paid for them.)

Ed Shin · Answer

Thanks for the helpful feedback and clarifying the terminology ("adjusted cost basis" v. "depreciable basis")!

So if some folks recommend allocating 100 percent of relevant closing costs and improvements made prior to being placed into service to dwelling structure versus allocating part to land and part to the dwelling structure, are they just more aggressively interpreting the regs?  (I noticed that Turbo Tax allocates part to land and part to the dwelling structure.)

Similarly, IRS regs seems to suggest - and some folks have stated - that only improvements made before placing the property into service can be added to the basis, while others say that repairs and landscaping done before placing the property into service can also be added to the basis.  Is this another case of conservative and aggressive interpretation of the regs?

Calculating Adjusted Cost Basis?

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