Your adjusted basis in real estate is the property’s tax cost after every qualifying addition and reduction over the years you owned it: purchase price plus qualifying closing costs, plus capital improvements, minus depreciation and other recoveries. When you sell, the IRS subtracts this number from the sale price to determine your gain or loss. The higher your adjusted basis, the smaller your taxable profit, so getting the figure right can be the difference between owing thousands in capital gains tax and owing nothing.
Where Your Basis Starts
Your initial cost basis is generally what you paid for the property, including the purchase price and certain closing costs.1Office of the Law Revision Counsel. 26 USC 1012 – Basis of Property Cost The specifics live on your Closing Disclosure or settlement statement. Not every line on that document qualifies, and the distinction matters.
Closing costs you can add to your basis include:
- Abstract and title search fees
- Owner’s title insurance
- Recording fees
- Transfer or stamp taxes
- Survey fees
- Legal fees for the title search, sales contract, and deed preparation
- Utility service line charges
IRS Publication 523 lists these as settlement fees that increase basis.2Internal Revenue Service. Publication 523, Selling Your Home If the seller owed back property taxes and you agreed to cover them, that amount folds in too.
Closing Costs That Do Not Count
Many of the biggest charges on your settlement statement are specifically excluded. Anything tied to getting the mortgage stays out: points, loan origination fees, the lender’s appraisal fee, credit report charges, mortgage insurance premiums, and loan assumption fees.2Internal Revenue Service. Publication 523, Selling Your Home Fire and casualty insurance premiums, rent you paid to occupy the house before closing, and pre-closing utility charges are also excluded. This is where people routinely overstate their basis by adding every closing cost to the pile.
What Adds to Your Basis
Money spent on capital improvements adds to basis over time. The work must add value, extend the property’s useful life, or adapt it to a new use, not just keep it running.3Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis Fixing a leaky faucet is a repair. Replacing all the plumbing is an improvement. The general rule: if the work lasts more than a year and meaningfully changes the property, it’s likely a capital improvement.
Publication 523 gives examples by category:2Internal Revenue Service. Publication 523, Selling Your Home
- Additions such as a bedroom, bathroom, deck, garage, porch, or patio
- Systems including heating, central air conditioning, wiring, security, and duct work
- Exterior work like a new roof, siding, storm windows, or insulation
- Plumbing including a septic system, water heater, or water filtration system
- Interior work such as kitchen modernization, built-in appliances, wall-to-wall carpeting, or flooring
- Lawn and grounds items including landscaping, driveway, fence, retaining wall, or swimming pool
One detail people miss: a repair done as part of a larger renovation counts as part of the improvement. Replacing one broken window is a repair. Replacing that same window while replacing every window in the house is part of a capital improvement.2Internal Revenue Service. Publication 523, Selling Your Home
Special Assessments for Local Improvements
If your local government charges you an assessment for improvements like paving roads, building sidewalks, or installing water connections, those assessments increase your basis.4Internal Revenue Service. Publication 551, Basis of Assets Don’t deduct them as taxes. You can, however, deduct any portion of the assessment that covers maintenance, repairs, or interest related to those improvements.
What Reduces Your Basis
Certain events and tax benefits pull your basis down over time. Each reduction reflects money you’ve already recovered, and the IRS won’t let you count that benefit twice when you sell.
Depreciation
If you rented the property or used part of your home for business, you were required to claim depreciation each year. Those deductions reduce your basis, and the IRS reduces it by the amount you were allowed to claim whether or not you actually claimed it.3Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis That last part catches people off guard. Skipping depreciation on your return doesn’t protect your basis. The “allowed or allowable” standard means the IRS reduces basis by the depreciation you should have taken.
Insurance Proceeds and Casualty Losses
Insurance money received after a fire, storm, or other casualty drops your basis by the amount of the reimbursement. If damage wasn’t fully covered and you claimed a casualty loss deduction, that deduction also reduces basis.5Internal Revenue Service. Property (Basis, Sale of Home, etc.) 3 Money you spent restoring the property afterward increases basis back up, partially or fully offsetting the reduction.
Easement Payments and Other Reductions
A payment from a utility company or government entity for an easement across your land reduces basis. Other items that decrease basis include the Section 179 deduction for business-use property, certain vehicle credits, and income exclusions for energy conservation subsidies.4Internal Revenue Service. Publication 551, Basis of Assets
Residential Energy Credits
If you claimed a federal residential energy credit for improvements like solar panels or energy-efficient windows, you must reduce your basis by the credit amount. The improvement still increases your basis, but only by the net cost after subtracting the credit.6Internal Revenue Service. Instructions for Form 5695 Install a solar energy system for $25,000 and claim a $7,500 credit, and only $17,500 gets added to basis.
Inherited Property Starts Differently
If you inherited the property instead of buying it, your starting basis is generally the fair market value on the date the previous owner died, not what they originally paid.7Internal Revenue Service. Gifts and Inheritances This is the stepped-up basis. If your parent bought a house in 1985 for $80,000 and it was worth $400,000 when they passed away, your starting basis is $400,000. All of that pre-death appreciation is wiped clean for tax purposes.
The estate’s executor may alternatively elect to use the property’s value on an alternate valuation date six months after death, but only when an estate tax return is filed and doing so reduces the estate’s total value and tax liability.7Internal Revenue Service. Gifts and Inheritances Either way, you’ll need the estate’s appraisal or the executor’s records to establish the number.
Gifted Property Carries the Donor’s Basis
Your basis in gifted property is generally the donor’s adjusted basis at the time of the gift: their original cost plus improvements, minus any depreciation they claimed. The IRS calls this carryover basis because the donor’s tax history carries over to you.4Internal Revenue Service. Publication 551, Basis of Assets
There’s a wrinkle when the property’s fair market value at the time of the gift was lower than the donor’s adjusted basis. In that situation you use two different figures: the donor’s adjusted basis to calculate a gain, and the fair market value at the time of the gift to calculate a loss.4Internal Revenue Service. Publication 551, Basis of Assets Sell for a price between those two numbers and there’s no gain or loss at all. This dual-basis rule trips people up and is worth reviewing with a tax professional before selling gifted property that has declined in value.
Running the Calculation
The formula is straightforward. Take your initial cost basis, add all capital improvements and other qualifying increases, then subtract all depreciation, casualty-related reductions, and other decreases.5Internal Revenue Service. Property (Basis, Sale of Home, etc.) 3 The result is your adjusted basis.
With numbers: you bought a home for $280,000 and paid $6,000 in qualifying closing costs, giving an initial basis of $286,000. Over the years you replaced the roof ($12,000), installed central air ($8,000), and added a deck ($15,000), for $35,000 in improvements. You claimed a $2,000 energy credit on the air conditioning, reducing basis by $2,000. Your adjusted basis is $286,000 + $35,000 − $2,000 = $319,000.
Sell that home for $475,000 and your gain is $156,000.8Office of the Law Revision Counsel. 26 USC 1001 – Determination of Amount of and Recognition of Gain or Loss
Why the Number Matters at Sale
Most homeowners selling a primary residence won’t owe capital gains tax, thanks to Section 121. If you owned and lived in the home as your principal residence for at least two of the five years before the sale, you can exclude up to $250,000 of gain, or $500,000 for married couples filing jointly when both spouses meet the use requirement and at least one meets the ownership requirement.9Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence In the example above, a single filer’s $156,000 gain falls entirely within the exclusion.
Even when the exclusion covers your gain, an accurate adjusted basis still matters. Anything above the exclusion is taxable, and in high-cost markets that ceiling gets real quickly.
If you claimed depreciation because the property was a rental or you had a home office, the sale triggers a separate tax called depreciation recapture. The portion of your gain attributable to depreciation is taxed at a maximum federal rate of 25%, regardless of your regular capital gains bracket.10Office of the Law Revision Counsel. 26 USC 1(h) – Tax Imposed – Maximum Capital Gains Rate Buy a rental for $300,000, take $50,000 in depreciation, and adjusted basis is $250,000. Sell for $400,000 and you have a $150,000 gain: the first $50,000 (the depreciation you deducted) is taxed at up to 25%, and the remaining $100,000 is taxed at your regular long-term capital gains rate. Skipping depreciation deductions during ownership doesn’t help, since basis is adjusted by what was allowable, not just what was claimed.3Office of the Law Revision Counsel. 26 USC 1016 – Adjustments to Basis
If you swap one investment property for another through a Section 1031 like-kind exchange, you don’t pay tax on the gain at the time of the exchange, but you don’t get a fresh basis either. Your basis in the new property starts at the adjusted basis of the old property, plus any additional cash you put in.11Office of the Law Revision Counsel. 26 USC 1011 – Adjusted Basis for Determining Gain or Loss The deferred gain is baked into the replacement property’s lower basis and is taxed when you eventually sell without doing another exchange.
Records to Keep, and For How Long
For property basis, the IRS says to keep records until the period of limitations expires for the year you dispose of the property.12Internal Revenue Service. Topic No. 305, Recordkeeping In practice that means holding every receipt, invoice, Closing Disclosure, and contractor bill for the entire time you own the property, plus at least three years after the return reporting the sale.
If you did a 1031 exchange, you also need the records from the original property you exchanged, potentially stretching your recordkeeping across decades and multiple properties.13Internal Revenue Service. How Long Should I Keep Records? Digital copies of receipts and settlement statements in cloud backup beat hauling boxes through every move. Reconstructing basis records years after the fact, if you can do it at all, costs far more than saving them as you go.