The depreciable basis for a rental property is what you paid for it (including certain closing costs), minus the value of the land, plus any capital improvements you make, minus depreciation you have claimed or were allowed to claim and any casualty-related reductions. That running figure is what you write off each year and what determines your tax bill when you sell. Getting it right at the start, and adjusting it correctly over time, is the single most important number in rental property taxation.
Start With Purchase Price Plus Qualifying Closing Costs
Your basis begins with what you paid the seller, but several settlement costs get added on top. The IRS lets you include legal fees for a title search, recording fees, survey charges, transfer taxes, owner’s title insurance, utility service installation charges, and any seller obligations you agreed to cover, such as back taxes or sales commissions.1Internal Revenue Service. Publication 551 – Basis of Assets
What stays out is just as important. Costs tied to getting your loan do not become part of the property’s basis. Points, loan origination fees, mortgage insurance premiums, loan assumption fees, lender-required appraisal fees, and credit report charges all fall on the loan side of the ledger.1Internal Revenue Service. Publication 551 – Basis of Assets Points paid on a rental property loan are generally deducted over the life of the loan.2Internal Revenue Service. Topic No. 504, Home Mortgage Points Rolling loan costs into basis is one of the most common errors, and it inflates your depreciation deductions in a way that surfaces during an audit or at sale.
Your closing disclosure lists every charge line by line. Keep it permanently. Pulling the correct numbers now saves hours of reconstruction later.
Subtract the Value of the Land
Land cannot be depreciated because it does not wear out.3Internal Revenue Service. Publication 946 – How To Depreciate Property Only the building and its structural components qualify. So once you have the total cost basis, you have to carve out the land portion.
The most common method uses the ratios on your local property tax assessment. If the assessor values land at $60,000 and building at $180,000, the building is 75% of the assessed total. Apply that 75% to your actual cost basis to find the depreciable amount.1Internal Revenue Service. Publication 551 – Basis of Assets An independent appraisal is another option, and it may pay for itself when you believe the tax assessment undervalues the structure. Whichever method you use, document your reasoning and apply it consistently.
One thing not to bury inside the land value: permanent improvements attached to the land. Fences, sidewalks, driveways, roads, bridges, and landscaping structures are 15-year property under the general depreciation system.3Internal Revenue Service. Publication 946 – How To Depreciate Property Track them separately from the building, and separately from the land, so you don’t forfeit deductions you are entitled to take.
Capital Improvements That Increase Basis
Your depreciable basis is not frozen at the purchase number. When you make a capital improvement, that cost is added to basis and depreciated over its own recovery period. An improvement is any expense that creates a betterment, restores the property, or adapts it to a different use. Replacing an entire roof, adding a room, installing a new HVAC system, or gutting and redoing the plumbing all qualify. Each improvement starts its own depreciation clock as if it were a separate asset.4Internal Revenue Service. Publication 527 – Residential Rental Property
The line between an improvement and a repair trips people up constantly. Patching a section of drywall is a repair you deduct immediately. Replacing every window in the building is an improvement you capitalize. When the answer is not obvious, two IRS safe harbors help.
De Minimis Safe Harbor
If the cost per item or per invoice is $2,500 or less (or $5,000 if you have audited financial statements), you can elect to deduct it immediately instead of capitalizing it. Make the election by attaching a statement to your tax return for that year.5Internal Revenue Service. Tangible Property Final Regulations Useful for smaller items like a replacement appliance or a water heater that technically qualifies as an improvement but falls under the threshold.
Routine Maintenance Safe Harbor
Recurring maintenance you reasonably expect to perform more than once during the first ten years of the building’s service life can be expensed rather than capitalized. The activity has to keep the property in ordinary operating condition rather than improve it beyond its original state.5Internal Revenue Service. Tangible Property Final Regulations Exterior painting and caulking are classic examples. The safe harbor does not cover betterments, so it will not save you on upgrades that increase capacity or quality.
Keep detailed receipts, contracts, and before-and-after descriptions for every project. In an audit, you carry the burden of proving whether a cost was a repair or an improvement, and that line is exactly where the IRS pushes.
Events That Decrease Basis
Adjustments run both directions. Section 1016 requires basis reductions for expenditures, receipts, and losses properly charged to the property’s capital account.6Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis The events that hit rental property owners most often:
- Annual depreciation. Each year’s depreciation lowers basis by that amount. The reduction is based on depreciation you were allowed to take, even if you forgot to claim it. Skipping depreciation for a few years does not preserve a higher basis; you must still reduce it by the full amount you were entitled to deduct. This is the “allowed or allowable” rule.3Internal Revenue Service. Publication 946 – How To Depreciate Property
- Casualty loss deductions. Claiming a deduction for damage from a fire, storm, or other sudden event reduces basis by the deducted amount.
- Insurance reimbursements. Money received from an insurance company for property damage also decreases basis, because it represents a recovery of your investment in the damaged portion.
The running total after all increases and decreases is your adjusted basis. That is the figure that matters for calculating remaining depreciation and eventual gain on sale.
Special Starting Points
Converting a Personal Residence to a Rental
Owners who convert a home they lived in into a rental face a different starting rule. The depreciable basis is not simply what you paid. You use the lesser of your adjusted basis on the date of conversion or the property’s fair market value at that time. If the home has dropped in value since you bought it, the lower fair market value becomes the ceiling on what you can depreciate. Land value comes off that figure as usual.
Adjusted basis in this context means your original cost plus capital improvements made while living there, minus any casualty losses you may have claimed. A declining market can significantly shrink the depreciable amount, which is a common and unpleasant surprise for first-time landlords. An appraisal at the time of conversion is worth the fee, because it establishes the fair market value you will rely on for years.
Inherited Property
When you inherit a rental property, the basis resets to the fair market value at the date of the decedent’s death.7Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent This step-up wipes out unrealized gain and prior depreciation for purposes of your new basis. If the decedent bought the property for $150,000 decades ago and it is worth $400,000 at death, your depreciable basis starts from the $400,000 value, minus land. An executor filing an estate tax return may elect an alternate valuation date six months after death if the property’s value has declined during that period.
Gifted Property
Gifts work differently. You generally take over the donor’s adjusted basis, including accumulated depreciation reductions.8Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust If the donor’s adjusted basis was $120,000, that is your starting point. One wrinkle: if the fair market value at the time of the gift is lower than the donor’s basis, you must use the fair market value when calculating a loss on any future sale. If gift tax was paid, a portion may increase your basis.9Internal Revenue Service. Property (Basis, Sale of Home, etc.)
The practical gap between the two is enormous. Inheriting gives you a high, fresh basis and large depreciation deductions. Receiving the same property as a gift saddles you with the donor’s old, reduced basis.
Replacement Property From a 1031 Exchange
When you swap one rental property for another under Section 1031, you do not get a fresh basis equal to the new property’s value. The basis of the property you gave up carries over to the replacement, preserving the deferred gain.10Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Exchange a property with an adjusted basis of $100,000 for one worth $300,000, and your basis in the replacement starts around $100,000, not $300,000. The $200,000 of deferred gain stays embedded in the new basis and will be taxed when you eventually sell outside of an exchange.
Why the Number Matters When You Sell
Every dollar of depreciation you claim reduces your basis, and the IRS collects on that reduction at sale. The portion of gain attributable to depreciation previously taken on real property, called unrecaptured Section 1250 gain, is taxed at a maximum rate of 25%, higher than the 15% or 20% long-term capital gains rate that applies to the rest of your profit.11Internal Revenue Service. Topic No. 409, Capital Gains and Losses
The allowed-or-allowable rule cuts hard here. Even if you never claimed a single depreciation deduction, recapture is calculated on the amount you were entitled to deduct.3Internal Revenue Service. Publication 946 – How To Depreciate Property Skipping depreciation does not lower your recapture bill. You just miss the deductions and still owe the tax as if you had taken them. That alone is reason enough to claim depreciation every year without fail.
Gain above the recapture amount receives the standard long-term capital gains rate. A 1031 exchange can defer both the regular gain and the recapture, though as noted, the deferred amounts carry forward into the replacement property’s basis.12Internal Revenue Service. Publication 544 – Sales and Other Dispositions of Assets