The cost basis of a rental property starts with the price you paid the seller, grows with qualifying purchase costs and later capital improvements, and shrinks each year by the depreciation you claim. That running figure determines how much depreciation you can deduct annually and how much taxable gain you’ll owe when you sell, so building it correctly from day one — and keeping it current — is one of the more consequential bookkeeping tasks you’ll take on as a landlord.
What Goes Into Your Starting Basis
Begin with what you actually paid the seller. Then add the acquisition costs you incurred to close and take ownership. The IRS draws a hard line between settlement costs tied to buying the property, which do count, and costs tied to getting a loan, which do not.1Internal Revenue Service. Publication 551 (12/2025), Basis of Assets
Costs that increase your basis include:
- Legal fees for the title search, contract preparation, and deed recording
- Title insurance (the owner’s policy premium)
- Transfer taxes imposed by the state or locality on the property transfer
- Survey fees required for closing
- Recording fees charged to record the deed with the county
Costs that do not go into basis include loan origination fees, mortgage points, and appraisal fees charged by your lender. Those are financing costs, handled separately through amortization or interest deductions.1Internal Revenue Service. Publication 551 (12/2025), Basis of Assets
Seller credits cut the other way. If the seller gave you a $5,000 credit at closing, your starting basis drops by that amount, because you effectively paid less for the property. If you agreed to pay something that was the seller’s obligation, such as back property taxes they owed, add that amount to your basis.
Money you spend getting the property ready for its first tenant — cleaning, minor repairs, utility hookups done before the property is placed in service — folds into the starting basis rather than being deducted as a current expense. Once you’ve totaled everything, you have your initial cost basis.
Splitting Basis Between Land and Building
You can’t depreciate land. Only the building and its structural components wear out for tax purposes, so before you calculate a single year of depreciation, split your total basis into a land portion and a building portion.2Office of the Law Revision Counsel. 26 USC 168 Accelerated Cost Recovery System
The simplest method borrows the ratio from your local property tax assessment. Most jurisdictions assess land and improvements separately. If your county assigns 20% of the assessed value to land and 80% to improvements, apply that same split to your cost basis. A professional appraisal is the stronger alternative, especially where the tax assessment seems off or where land value is unusually high relative to the building. Either way, the split has to be reasonable and consistent; an allocation that minimizes land purely to inflate the depreciable portion won’t hold up under scrutiny.
The amount allocated to the building is what enters your depreciation calculation. Residential rental property uses the straight-line method over a 27.5-year recovery period.2Office of the Law Revision Counsel. 26 USC 168 Accelerated Cost Recovery System Divide the building’s basis by 27.5 for your annual deduction.
What Raises Basis After You Buy
Every dollar you spend on the property after closing falls into one of two buckets: a deductible repair or a capitalized improvement. Repairs keep the property in its current condition — fixing a leaky faucet, patching drywall, replacing a broken window — and come off your taxes the year you pay them, without touching basis.
Improvements are different. Under the IRS tangible property regulations, you must capitalize anything that counts as a betterment, restoration, or adaptation.3Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions A betterment fixes a pre-existing defect, enlarges the property, or materially increases its capacity. A restoration brings a worn-out property back to working condition or replaces a major component. An adaptation converts the property to a new use. A new roof, a full kitchen remodel, an added bedroom — each of those gets added to basis and starts its own 27.5-year depreciation schedule.
Two safe harbor elections let smaller spending skip the capitalization process. The de minimis safe harbor lets you deduct items costing $2,500 or less per invoice (or $5,000 if you have audited financial statements) rather than capitalizing them.3Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions The safe harbor for small taxpayers lets landlords with average annual gross receipts of $10 million or less, and buildings with unadjusted basis under $1 million, deduct repair and improvement costs up to the lesser of 2% of the building’s unadjusted basis or $10,000. Both elections must be made annually on your tax return. When you use them, those costs don’t go into basis — you’ve deducted them currently instead.
Keep every invoice. Without documentation, you can’t substantiate a higher basis when you sell, and that translates directly into a bigger capital gains bill.
What Lowers Basis Each Year
Every year you depreciate the building, your adjusted basis drops by the deduction amount. Over 27.5 years, the depreciable portion falls to zero. A lower basis means a larger taxable gain at sale.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property
The trap most landlords don’t see coming: the IRS reduces your basis by the depreciation “allowed or allowable,” whichever is greater.5Office of the Law Revision Counsel. 26 US Code 1016 – Adjustments to Basis If you forgot to claim depreciation for three years, the IRS still treats your basis as if you did. You can’t skip deductions now and claim a higher basis later. If you’ve been missing depreciation, file Form 3115 to catch up through a change in accounting method — far better than letting those deductions evaporate.
Basis also decreases for uninsured casualty losses you deduct (storm or fire damage) and for certain energy or rehabilitation tax credits that require a corresponding basis reduction.
One related tool worth knowing about even though it doesn’t change your basis: a cost segregation study reclassifies parts of the building into shorter recovery periods (5, 7, or 15 years), front-loading your depreciation. It changes the speed of basis recovery, not the total.6Internal Revenue Service. Publication 946 (2025), How To Depreciate Property
Starting Basis in Special Situations
Not every rental property starts with a straightforward purchase. Four situations have their own starting-basis rules.
Inherited Property
When you inherit a rental, your basis is the fair market value on the date the previous owner died — a “stepped-up” basis that wipes out all prior appreciation and resets the depreciation clock.7Office of the Law Revision Counsel. 26 USC 1014 Basis of Property Acquired From a Decedent If a parent bought a rental for $150,000 and it was worth $400,000 at their death, your basis is $400,000.
Fair market value usually comes from a qualified appraisal around the date of death, or from the value reported on Form 706 if an estate tax return was filed. When Form 706 is filed and the IRS accepts the reported figure, that figure becomes binding for your basis too. An executor can elect to value the estate six months after death instead, but only if doing so decreases both the total estate value and the estate tax owed. The election is irrevocable.8Office of the Law Revision Counsel. 26 US Code 2032 – Alternate Valuation
Gifted Property
Gifts don’t get the same reset. You generally take over the donor’s adjusted basis — what they paid, plus their improvements, minus depreciation they claimed. This is called carryover basis.9Office of the Law Revision Counsel. 26 USC 1015 Basis of Property Acquired by Gifts and Transfers in Trust
If the property’s fair market value at the time of the gift was lower than the donor’s adjusted basis, a “dual basis” rule kicks in.1Internal Revenue Service. Publication 551 (12/2025), Basis of Assets For calculating gain at sale, you use the donor’s adjusted basis. For calculating loss, you use the lower fair market value at the time of the gift. If your sale price lands between those two figures, you recognize no gain or loss at all. For depreciation on gifted property used in business, your starting point is the donor’s adjusted basis.
A Personal Residence Converted to a Rental
Converting your home into a rental creates a split basis that trips up more landlords than almost any other rule. For depreciation, your basis is the lower of your adjusted cost basis or the property’s fair market value on the date you place it in service as a rental.4Internal Revenue Service. Publication 527 (2025), Residential Rental Property This prevents you from depreciating any decline in value that occurred while you lived there.
Say you bought your home for $300,000 and put $40,000 into improvements, giving you a $340,000 adjusted basis. If the home is worth $290,000 when you convert it to a rental, your depreciation basis is $290,000. You still allocate between land and building from there.
Gain and loss at eventual sale use different numbers. Gain basis is your original adjusted cost basis ($340,000) minus depreciation taken. Loss basis is the fair market value at conversion ($290,000) minus depreciation taken. The gap between those figures can create a zone where you sell at a nominal loss from your original investment but recognize nothing for tax purposes, because the loss occurred during personal use.
Get an appraisal on the day you convert. One document supports your depreciation basis, your future gain-or-loss calculation, and any Section 121 proration if you later qualify for the home sale exclusion.10Internal Revenue Service. Publication 523 (2025), Selling Your Home Without it, you’re reconstructing numbers years later.
Property Received in a 1031 Exchange
A 1031 like-kind exchange defers capital gains tax by carrying your old basis forward into the replacement property rather than giving you a fresh start. The basis of the replacement equals the basis of what you gave up, decreased by any cash you received and adjusted for any gain or loss recognized on the exchange.11Office of the Law Revision Counsel. 26 US Code 1031 – Exchange of Real Property Held for Productive Use or Investment
In practice, if you trade a property with a $200,000 adjusted basis for one worth $350,000 and pay $150,000 in additional cash with no boot received, your basis in the new property is $350,000: $200,000 carryover plus $150,000 of new money. The carryover portion continues depreciating over the old asset’s remaining life, and the new money starts its own 27.5-year clock. A 1031 doesn’t reset your basis; it preserves the lower figure in the replacement.
Why Your Running Basis Matters at Sale
All those years of depreciation come back when you sell. The total depreciation you claimed, or were entitled to claim, is “recaptured” and taxed at a rate of up to 25% — higher than the long-term capital gains rate that applies to the rest of your profit. This is unrecaptured Section 1250 gain, reported through Part III of Form 4797.12Internal Revenue Service. 2025 Instructions for Form 4797 – Sales of Business Property
A simplified example: you bought a rental for $300,000, allocated $240,000 to the building, and claimed $87,273 in depreciation over ten years. Your adjusted basis is now $212,727. Sell for $350,000, and your total gain is $137,273. The $87,273 depreciation portion is taxed at up to 25%; the remaining $50,000 is taxed at your regular long-term capital gains rate.
This is why the “allowed or allowable” rule bites so hard. Even if you never claimed a dollar of depreciation, the IRS treats the full allowable amount as taken and charges you recapture on it.5Office of the Law Revision Counsel. 26 US Code 1016 – Adjustments to Basis Skipping depreciation doesn’t spare you from the recapture tax; it just means you paid more income tax along the way for no benefit. Track your basis every year, claim your depreciation every year, and keep the records that let you prove both.