How to determine the base for an appreciated rental property?

Question

Hi fellow investors, I would like to get your advice on how to determine the basis (for both cost basis and depreciation purposes) for a rental property that has appreciated considerably (say from 400k to 500k) from the time it was purchased (say after 6 months), but before leasing out? Since the market value has changed a lot (100k in this case), should the basis be the new market value prior to renting out (i.e., 500k)? If so, how to provide support for the new basis, which is much higher (100k) than the original purchase price?

Thank you very much for your attention and advice in advance.

Best.

Yan

Frank Chin · Answer

@Yan Kang

The cost basis is baked in when you purchase, no matter the appreciation. I rented out property after living there over ten years, converting to a rental, and the basis is still what I paid for the property ten years before. In the ten year period, with high appreciation in NY, prices went up three times.

Depreciation is based on what is allowed depreciation the property is placed into service. I owned a triplex, got it in 1983. I rented out two units, and the basis is allocated 2/3 of purchase of the structure, i.e. less land value. The depreciation in effect in 1983 allows accelerated depreciation over 15 years. When I moved out of my unit in 1993, the value of the building is up 3 times, but the allocated basis is still 1/3 of the purchase price of the structure in 1983, less land value, but the depreciation is under laws in effect in 1993, 27.5 years straight line. It goes on the schedule E as two separate assets.

Frank Chin · Answer

Exactly. Like any business, you got to be able to calculate your profits and capital gains. In real estate, keeping track of the cost basis is keeping track of "how much you got it for" so you can eventually figure out your capital gains. It is also used in depreciation calculations. Being ten years later doesn't change how much you got it for.

Yan Kang · Answer

Hi Frank, thanks for your comments. To clarify: you bought the triplex in 1983, lived there for 10 years, and then rented it out in 1993, right? So you still used your original purchase price as the cost basis and the price of the building (total price - land value) in 1983 for depreciation value, instead of using the market value of the property in 1993? Thanks. Yan