When you obtain a mortgage to purchase real property, it's likely that the total loan amount accounts for a large portion of your tax, or cost, basis. This is true for a property you acquire for investment purposes as well as the home you live in with your family. But aside from the portion of the property's purchase price you finance with a mortgage, other costs you incur can increase your tax basis as well.
Significance of Cost Basis
Regardless of whether the property is your residence or an investment, it's taxed under the capital asset rules. Your basis in a capital asset represents all of the costs you incurred to acquire it that you can recover tax free if you ever sell it. The total proceeds from the sale -- which includes all cash and the value of other property received in the exchange, minus your cost basis in the property sold -- is the amount of capital gain or loss you'll report on your return. How this gain or loss impacts your tax bill depends on whether it's personal or investment property and if it's used as your main home -- factors that are unrelated to its basis.
Property's Purchase Price
A more accurate starting point for figuring out the cost basis of your real estate is the purchase price rather than the total mortgage debt. This is because your overall cost is usually more than the total mortgage loan. In a typical home purchase, it's unlikely that the mortgage lender will finance the property's entire purchase price and will require a down payment. For example, if you purchase a home for $300,000 and put down 10 percent -- you take out a mortgage for $270,000, for example -- your total mortgage is certainly included in the property's $300,000 cost basis, but so is the $30,000 that you didn't need to borrow.
Increases to Basis
Your cost basis also covers many of the typical expenses that buyers pay when purchasing real estate. You can increase basis for unpaid real estate taxes you paid on behalf of the seller and a wide range of settlement costs. Settlement costs that increase basis include the fees you pay for title abstracts, to install utility services, legal and recording fees, transfer taxes and the charges for surveying services. You cannot increase basis, however, for the interest or points you pay on the mortgage, as these are deductible over the life of the mortgage loan. After the property purchase is complete, cost basis also increases for the expense of making permanent improvements, such as the total cost to install an in-ground pool or to build an outside deck.
Depreciation on Income-producing Properties
Properties used for residential, investment and rental purposes include the same costs in basis. When a property is income producing, such as the homes you ordinarily rent to tenants, you can depreciate its cost basis. Depreciation deductions allow you to recover your total cost -- your basis -- over a number of years. If you take depreciation deductions on the property, it will reduce the tax you owe for the year. But each deduction also reduces your basis, which means your taxable gain will increase if, and when, you sell the property.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.