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    Investing in rental property is all about making money. Unfortunately, earning on a rental property means paying taxes on your income. Knowing key financial metrics about your rental property can help you estimate how much you’ll owe during tax season.

    The adjusted basis is one of the most important metrics for calculating your tax burden. It’s primarily used to calculate capital gains and losses during tax season to determine how much you’ll owe for that year. However, it can also be used to calculate depreciation deductions you can claim on your taxes to reduce your taxable income and calculate your total rental income to determine your return on investment (ROI).

    But what is the adjusted basis of a rental property, and how can you calculate this key financial metric to gauge profitability? Keep reading to learn more about adjusted basis for rental property and how you can use it to increase your returns.

    KEY TAKEAWAYS

    • The adjusted basis of a rental property is a fundamental component for calculating taxation and can help you assess the financial performance of your investment.
    • The IRS uses your adjusted basis to determine whether you experienced capital gains or losses from your investment properties.
    • The adjusted basis is only used to calculate taxes after you’ve sold the property.

    What Is the Adjusted Basis of a Rental Property?

    The adjusted basis, also known as the adjusted cost basis, of a rental property is a financial calculation used to calculate how much you’ll owe in taxes based on your capital gains or losses. It can also help you measure the ROI of an investment property.

    To understand the adjusted basis, you must first understand the basis. In real estate, the basis refers to the cost of the investment property, including the purchase price and associated fees. Also known as the cost basis, which calculates capital gains or losses for tax purposes when you sell a property.

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    A high adjusted basis means lower gains, and whether you take out investment property loans doesn’t matter since it’s not factored into this question. Instead, the basis only refers to the purchase price of the property and realtor fees.

    The adjusted basis is when the basis – the purchase price of a property — is adjusted based on expenses associated with the property. For instance, rental properties require regular maintenance and insurance, while depreciation brings the value of the property down.

    Adjusting the basis allows you to determine how profitable an investment property is once it’s sold. It won’t help you determine the profitability of a long or short-term rental while you still own it and collect rental income.

    The adjusted basis doesn’t factor in rental income or expenses associated with being a landlord. Instead, it only comes into play when the property is sold because the IRS treats rental income as regular income, not capital gains or losses associated with investments.

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    How Does Adjusted Basis Work?

    Let’s review: The adjusted basis of a rental property is the total cost of the property based on increases or decreases in value. When you sell an investment property, you’ll use the adjusted basis to calculate your returns by factoring in your expenses, which can result in capital gains or losses.

    The adjusted basis starts with the original purchase price of the property — how much you paid for it whether or not you used an investment property, DSCR loan, or any other type of mortgage. Again, this original number is called the basis.

    Two things can happen to your basis over time: your adjusted basis can increase or decrease when you choose to sell the property.

    When the basis increases, it reduces the amount of taxes you owe when you sell because it reduces your capital gains. On the other hand, when the basis decreases due to credits, reimbursements, and other deductions, your capital gains increase, and so will the amount you owe in taxes.

    What Expenses Are Included in the Adjusted Basis?

    You can find the adjusted basis by adding or subtracting various costs from the original basis. Expenses included in the calculation include:

    • Improvements: If you make improvements, repairs, or additions to the property, it typically increases its value.
    • Depreciation: The IRS assumes a rental property loses value — depreciates— every year. Depreciation deductions allow investors to recover the cost of the property.
    • Losses: Casualty losses include property damages or financial losses due to fires, storms, and theft. If the investor can’t recover the loss, they’re given a deduction, reducing the adjusted basis.

    Other expenses may affect the basis, including impact, zoning, and legal fees. However, in general, deductions on expenses for the year they were incurred are not included in the adjusted basis.

    For instance, some deductible expenses like repairs and maintenance are not included in the adjusted basis because they’re deducted in the year you file your taxes.

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    How Do You Calculate Adjusted Basis for a Rental Property?

    To calculate the adjusted basis for a rental property, you begin with the purchase price and add the cost of improvements, which increase the property’s value. Then, you subtract the expenses, such as depreciation and losses. The final number is your adjusted basis for a rental property, which determines whether you’ve had a capital gain or loss when you sell the property.

    Adjusted Basis = Original Basis + Capital Improvements – Depreciation – Casualty Losses

    Adjusted Basis Example

    Let’s look at an example to help you understand the adjusted basis of a rental property. Say you decided to invest in San Diego real estate and purchased a single-family home for $250,000 and used an asset-based loan in the amount of $200,000, meaning you paid $50,000 in cash.

    To calculate the adjusted basis, you only need to know that you paid $250,000 for the property — your home loan doesn’t matter.

    Next, you can add any associated fees like taxes paid, closing costs, and realtor commissions fees paid to purchase the property. For this example, we’ll say those fees totaled $15,000.

    Your basis is now $265,000. This is how much you spent to purchase the property.

    Over the last five years, you’ve invested $20,000 into improvements and repairs, and your home was damaged in a storm that cost $5,000 to repair, and the property has not depreciated in value.

    To calculate your adjusted basis, you add and subtract associated costs during the time you’ve owned the property. Let’s plug these numbers into our formula:

    Adjusted Basis = $265,000 + $20,000 – $0 – $5,000 = $280,000.

    Your adjusted basis is $280,000. So what does this mean? Ultimately, it means you’ve made a return on your investment by $30,000 when you sell the property, and you’ll have to pay capital gain taxes during that same tax season.

    Here is how to calculate your capital gain when you sell the property:

    1. Sale price = $700,000
    2. Subtract real estate commissions / closing costs of $50,000
    3. Adjusted sales price = $650,000
    4. Subtract adjusted basis of $280,000
    5. Capital gain = $370,000

    As you can see, we can use the adjusted basis to calculate the capital gain on a home that was originally acquired for $250,000 and then later sold for $700,000. In this example, $370,000 is the capital gain and thus the amount that will be taxed unless you do a 1031 exchange and defer the taxes.

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    Earning rental income can help you passively build wealth, but what happens when you decide to sell the property? While rental income counts as regular income during tax season, profits from selling an investment property are taxed as capital gains or losses. Knowing your adjusted basis can help you plan during tax season while ensuring your property stays profitable.

    However, adjusted basis isn’t the only way to measure a rental income’s profitability. Since it doesn’t factor in your monthly mortgage or rental income, it can’t give you an accurate estimate of how much you can earn by investing in rental property.

    Invest in rentals with Griffin Funding. As a premier lender of investment property, conventional, and non-QM loans like bank statement loans, we can help you find the best mortgage program to keep your mortgage affordable. Contact us today at 855-698-1098 or fill out an online application.

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    Frequently Asked Questions

    Is it better to have a higher or lower adjusted basis?

    If the goal is to pay less in taxes, it's better to have a higher adjusted basis, which means you have lower capital gains when you sell the property. On the other hand, if your main concern is profits, you might want a lower adjusted basis even though you'll pay more in taxes.

    Do you have to use an adjusted basis for your rental property?

    The adjusted basis for rental properties is only used to determine capital gains for taxes in the year you sell the property. It's not a metric you need to use on a yearly basis or if you still own the property. Since rental property income is taxed as ordinary income, the IRS won't need to calculate your adjusted basis to determine how much you owe.

    How do you report adjusted basis on a rental property?

    You'll report the adjusted basis on a rental property on IRS Form 4797 or Schedule D of Form 1040 in the year you sell the property. Schedule D is for gains and losses on personal property, while Form 4797 is for property used to conduct business.

    It's possible that your property is for personal and business use, in which case you'll need both forms.

    What's the best type of loan for a rental property?

    There is no single best type of loan for a rental property since the right loan for you will depend on your personal financial situation, investment strategy, and the type of property you want to purchase. Conventional and DSCR non-QM loans are the most popular types of loans for rental properties.

    The best way to determine the right loan for a rental property is to contact a lender like Griffin Funding to evaluate your financial situation and goals to find the best solution.
    Bill Lyons

    Bill Lyons is the Founder, CEO & President of Griffin Funding. Founded in 2013, Griffin Funding is a national boutique mortgage lender focusing on delivering 5-star service to its clients. Mr. Lyons has 22 years of experience in the mortgage business. Lyons is seen as an industry leader and expert in real estate finance. Lyons has been featured in Forbes, Inc., Wall Street Journal, HousingWire, and more. As a member of the Mortgage Bankers Association, Lyons is able to keep up with important changes in the industry to deliver the most value to Griffin's clients. Under Lyons' leadership, Griffin Funding has made the Inc. 5000 fastest-growing companies list five times in its 10 years in business.