What Is Adjusted Cost Base, and How Is It Calculated?

To start, it's important to point out that an adjusted cost base is the same thing as an adjusted cost basis. While the former term is more common in Canada, the latter term is primarily used in the United States. However, conceptually, they are the same.

That said, if you are unfamiliar with this concept and its effect on your tax return, keep reading for an explanation.

What is an adjusted cost base?

Understanding cost base

Before you can wrap your head around an adjusted cost base, it's important to have an understanding of the term "cost base" itself. Put simply, an item's cost base is defined as the value of an item for tax purposes. Specifically, it refers to the item's purchase price, plus any costs of acquisition.

An item's cost base is primarily used for determining how much an investor owes in capital gains tax when the item is sold. You can find out how much you owe in capital gains tax by subtracting an item's cost base from its fair market value, or how much it sold for at the time of the sale.

Adjusted cost base vs. unadjusted cost basis

Now that you have a better understanding of cost base and how it is used, the next step is to learn about adjusted cost base and unadjusted cost base.

As the name suggests, an adjusted cost base occurs when the cost basis of an item is adjusted over time to reflect changes to its value. Meanwhile, an unadjusted cost base stays the same for the entire length of time that the asset is held by its owner.

When is an adjusted cost basis used?

Put simply, if the asset's value does not change over time, an unadjusted basis is used to calculate any capital gains. However, if change does occur, you would use an adjusted basis instead. In particular, there are three instances where an adjusted basis is more common.

1. Capital improvements or depreciation: Real estate is probably the most common example of this. Improvements made by a property owner increase their adjusted basis, while depreciation slowly decreases their basis. Still, if you have another asset that you can depreciate, such as a piece of heavy machinery, then an adjusted basis can be claimed.
2. Inheritance: When someone inherits an asset after a loved one's death, they receive what's known as a step-up in basis. In this case, the stepped-up basis is equal to the current fair market value of the asset. In some cases, especially when highly-appreciated property is involved, this step-up can be significant and help beneficiaries avoid hefty tax bills when they sell the property.
3. Stock events: Some stock events, such as a stock split for a dividend that gets paid in the form of additional shares, can be cause for an adjusted basis being used.

How to calculate the adjusted tax basis of an investment property

The last step in this process is to learn how to calculate an adjusted tax basis. However, before you do that, it's important to have an idea of some common increases and decreases to a tax basis. We've listed some out for you below.

Additionally, it's important to keep in mind that a higher cost basis generally benefits you at tax time because it will lower your taxable gain.

Common increases

1. The cost of any improvements made to the property
2. Money spent to replicate the property after damages
3. Any tax credits
4. Any legal fees
5. Costs to add utilities to the property

Common deductions

1. Depreciation on the property
2. The amount of any payouts you receive from insurance after a loss
3. The cost of any casualty losses not covered by insurance
4. Payments you receive from granting an easement

Calculating adjusted cost base: An example

For the purposes of this example, let's say you bought an investment property worth $500,000. However, in the process of buying the property, you also spent $20,000 in closing costs. Then, after settlement, you spent another $50,000 on capital improvements to the property.

Here, your original cost basis would be $570,000, or $500,000 + $20,000 + $50,000.

Or, let's say that you own the property for 10 years, and you depreciate the property at a rate of $10,000 per year. In that case, you would have depreciated a total of $100,000 from the property, which makes your adjusted cost basis equal to $470,000, or $570,000 - $100,000.

The bottom line

It's important for property owners and investors to have an idea of what adjusted cost basis is and how to calculate it. You can use this post as a guide to adjusted cost basis and how to do your own calculations.

However, if you have specific questions about your capital gain for this tax year or how to lower it, your best bet is to ask a professional for tax advice. They can give you cost basis information that is specific to your needs.