How to Calculate the Adjusted Basis of Property

To calculate the adjusted basis of property, start with what you paid for it (including certain purchase costs), add every capital improvement you made while you owned it, and subtract items like depreciation, casualty losses, and insurance reimbursements you kept. The formula is short: original cost basis + capital improvements − required reductions = adjusted basis. Each piece has its own rules, and getting any of them wrong can shift your taxable gain by tens of thousands of dollars when you sell.

Step 1: Start With Your Original Cost Basis

Your starting number is the cost basis: the amount you paid for the property, plus certain costs of the purchase itself.¹ The best source for this figure is the Closing Disclosure (or older HUD-1 settlement statement) from the day you bought the property. It lists both the price and every fee paid at closing.

Closing Costs You Can Add

Per IRS Publication 551, the following purchase-related fees become part of your basis:

Abstract and title search fees
Legal fees for preparing the sales contract and deed
Recording fees
Surveys
Transfer taxes
Owner’s title insurance
Charges for installing utility services
Seller obligations you agreed to pay, such as back taxes, sales commissions, or repair charges

The working test: a fee counts if you would have paid it even if you bought the property with cash. If the fee is tied to buying the property, add it. If it is tied to financing the property, do not.²

Closing Costs You Cannot Add

These loan-related costs do not increase basis:

Points (discount points and loan origination fees)
Mortgage insurance premiums
Loan assumption fees
Credit report fees
Lender-required appraisal fees
Casualty insurance premiums
Prepaid rent or utility charges for occupying the property before closing

Points are usually deductible over the life of the loan instead.² Mixing deductible loan costs into basis is one of the most common errors at this step.

If your closing documents are missing, contact the title company or real estate attorney who handled the transaction. Every dollar you document here is a dollar of taxable gain you will not owe on later.

Step 2: Add Capital Improvements

Increase your cost basis by every qualifying capital improvement made during your ownership. Amounts paid for permanent improvements or betterments that add to the property’s value are capital expenditures; they cannot be deducted as current expenses but must be added to basis.³ Basis must be adjusted for improvements and other items properly chargeable to the capital account.⁴

Common capital improvements:

Adding a room, deck, garage, or porch
Replacing the roof, HVAC system, or plumbing
Installing a new septic system or water heater
Permanent landscaping such as retaining walls, driveways, or fencing
Kitchen or bathroom remodels that go beyond cosmetic repairs

Routine repairs and maintenance do not add to basis. Fixing a leaky faucet, repainting a room, patching drywall: none of these count. The dividing line is whether the work extends useful life, adapts the property to a new use, or adds measurable value, versus simply keeping the property in its existing condition.

Demolition and Land Preparation

If you buy property intending to tear down an existing building, the entire purchase price (including any value assigned to the building) is allocated to the land. Net demolition costs are then added to the land’s basis.⁵ Site-clearing, grading, and utility installation before new construction follow the same logic: they enter the basis of the land or the new structure rather than being deducted.

Keep every receipt and invoice, each showing the date, the total amount, and a description of the work. Local building permits can back you up if receipts get lost.

Step 3: Subtract Required Reductions

Several events and deductions pull your basis back down. Missing any of them means understating your gain when you sell, which can trigger penalties and interest.

Depreciation: Allowed or Allowable

Depreciation is the biggest reduction for rental and business property. Each year’s deduction on Form 4562 lowers your remaining basis.⁶ Prior-year returns will show the cumulative total.

Here is the rule that trips people up. You must reduce basis by the greater of the depreciation you actually claimed (“allowed”) or the amount you were entitled to claim (“allowable”).⁷ Rented the property for five years and never claimed depreciation? The IRS still cuts your basis by the amount you could have deducted. Skipping the deduction does not preserve a higher basis; it just wastes the tax benefit.

Casualty Losses and Insurance Reimbursements

If you took a casualty loss deduction after a natural disaster or other qualifying event, the deducted amount reduces basis. Separately, insurance money you received for property damage that you did not spend on repairs also reduces basis. If your insurer paid $10,000 for fire damage and you spent only $6,000 fixing it, the unspent $4,000 comes off your basis.

Easement Payments

Money you receive for granting an easement or right-of-way is treated as a partial sale. The payment reduces the basis of the affected portion. If the payment exceeds that portion’s basis, drop the basis to zero and report the excess as a recognized gain.²

Energy-Efficiency Credits

If you claimed the energy efficient home improvement credit under Section 25C for upgrades like insulation, windows, or heat pumps, the credit reduces the basis increase you would otherwise get from the improvement. You still add the cost of the improvement to basis, but you subtract the credit you received.⁸

Step 4: Run the Numbers

Once you have the three components, the math is direct:

Original cost basis + Capital improvements − Total reductions = Adjusted basis

A worked example. You buy a rental property for $200,000 and pay $4,000 in qualifying closing costs, giving you an original cost basis of $204,000. You add a new roof for $15,000 and replace the HVAC for $8,000, bringing the running total to $227,000. Over the rental years you claim $30,000 of depreciation. Your adjusted basis is $227,000 − $30,000 = $197,000.

When you sell, subtract the adjusted basis from the net sales price (sale amount minus selling expenses like agent commissions). Net sale of $310,000 produces a recognized gain of $310,000 − $197,000 = $113,000.

When Your Starting Basis Is Not What You Paid

The starting number in Step 1 assumes you bought the property in an ordinary purchase. If you acquired it another way, the starting basis changes, and you build the rest of the calculation on top of that.

Inherited Property

Inherited property generally does not carry the deceased owner’s original cost basis. The basis resets to the fair market value on the date of the decedent’s death.⁹ This is often called a stepped-up basis because, for appreciated property, the basis steps up to market value and wipes out the built-in gain from the prior owner’s lifetime.

If the executor files a federal estate tax return (Form 706), an alternate valuation date six months after death may be elected instead.¹⁰ When an estate tax return is required, the executor must also file Form 8971 and give each beneficiary a Schedule A reporting the property’s value, and you generally must use a basis consistent with that value.¹¹ From that stepped-up figure, you adjust for your own later improvements and depreciation the same way any other owner would.

Gifted Property

Basis in gifted property depends on how the donor’s adjusted basis compares to the fair market value at the time of the gift.¹²

If FMV is equal to or greater than the donor’s basis, your basis is the donor’s adjusted basis (a carryover basis). Donor paid $100,000, worth $250,000 at the gift: your basis is $100,000.
If FMV is less than the donor’s basis, a dual-basis rule applies. Use the donor’s basis to calculate a gain on a later sale, but use the lower FMV to calculate a loss. Sell for a price between the two, and you have neither gain nor loss.

If the donor paid federal gift tax on the transfer, part of that tax may increase your basis. For gifts made after 1976, the increase is limited to the share of gift tax attributable to the property’s net appreciation, not the full tax paid.¹³ The formula: (net appreciation ÷ amount of the gift) × gift tax paid. Donor’s basis $60,000, FMV at gift $90,000, gift tax paid $33,300: the basis bump is ($30,000 ÷ $90,000) × $33,300 = $11,100.

Property From a Like-Kind Exchange

If you acquired the property through a Section 1031 like-kind exchange, basis does not reset to the new property’s purchase price. The basis of the property you gave up carries over to the replacement property, decreased by any cash you received and adjusted for any gain you recognized on the exchange.¹⁴ This carryover reflects the deferred gain from the original property. Sell the replacement in a later taxable sale and you will owe tax on that deferred gain along with any new appreciation.

Keep the Records That Prove Your Basis

Hold on to every basis document, closing statements, improvement receipts, depreciation schedules, and insurance settlement letters, for as long as you own the property, plus at least three more years after you file the return reporting the sale. Three years is the general statute of limitations for income tax returns.¹⁵ The retention period stretches to six years if you omit more than 25% of your gross income from a return, and seven years if you claim a loss from worthless securities or bad debts.

If you acquired the property through a nontaxable exchange, keep records for both the old and the new property until the limitations period ends for the year you sell the replacement.¹⁵ If originals are lost to a fire, flood, or similar event, the IRS allows you to reconstruct costs using reasonable secondary evidence: bank statements, contractor estimates, and county permit records will generally do the job.

1
Office of the Law Revision Counsel. 26 USC 1012 – Basis of Property-Cost
2
Internal Revenue Service. Publication 551 Basis of Assets
3
Office of the Law Revision Counsel. 26 USC 263 – Capital Expenditures
4
Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
5
eCFR. 26 CFR 1.165-3 – Demolition of Buildings
6
Office of the Law Revision Counsel. 26 USC 167 – Depreciation
7
Internal Revenue Service. Depreciation Recapture 3
8
Office of the Law Revision Counsel. 26 USC 25C – Energy Efficient Home Improvement Credit
9
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
10
Internal Revenue Service. Gifts and Inheritances
11
Internal Revenue Service. Instructions for Form 8971 and Schedule A
12
Office of the Law Revision Counsel. 26 USC 1015 – Basis of Property Acquired by Gifts and Transfers in Trust
13
eCFR. 26 CFR 1.1015-5 – Increased Basis for Gift Tax Paid
14
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
15
Internal Revenue Service. How Long Should I Keep Records