The term "adjusted basis" may sound like it's something just used by accountants and tax professionals. However, it's an important term for all investors to know. With that in mind, we've created the guide on adjusted basis below. Keep reading to learn what an adjusted basis is and how to calculate it.
What is a cost basis?
Before we can get started talking about the intricacies of an adjusted basis, it's critically important to understand what a cost basis is and how it works.
At its core, the term "cost basis'' (or "cost base") refers to the original value or purchase price of an asset. It is generally used for tax purposes, specifically to calculate any capital gain when the asset is sold. Capital gains are measured as the difference between the cost basis and the fair market value of the asset.
As an investor, knowing an asset's original basis is important because it can save you money over time. While the short-term capital gains tax rate is about as much as ordinary income, if you hold an asset in your portfolio for a while, you can qualify for the long-term capital gains tax rate, which is much lower.
What's the difference between an adjusted basis and an unadjusted basis?
Now that you understand what a cost basis is, the next step is to learn about the difference between the two different types of cost basis that you can use for tax purposes. There is an adjusted basis and an unadjusted basis.
With an adjusted tax basis, you can adjust the cost basis to account for any increases or decreases to its original value. For example, you can subtract any costs that you took as deductions on your tax return. Alternatively, if you made any capital improvements to the asset, you can use those to increase its tax basis.
On the other hand, an unadjusted basis does not get adjusted over time. In this case, your original basis, or the amount that you paid for the asset when you first bought it, remains the same for the entire time that the asset is kept in your portfolio.
When is an adjusted basis used?
There are three main instances where an adjusted tax basis can be used in place of an unadjusted tax basis:
- Depreciation or improvements: When depreciation can be claimed for any wear and tear on an asset such as an investment property or a piece of heavy machinery, that will change its tax basis. By the same token, any improvements done to these items can also increase the tax basis.
- Inheritance: When someone inherits an asset following a loved one's death, they typically receive what's known as a step-up basis. This means that an adjustment is made to the asset's original basis so that the basis becomes equal to the current fair market value for federal income tax purposes.
- Stocks: Certain stock events can also trigger the use of an adjusted basis. For example, if you receive a dividend payment in the form of additional stock shares, it will cause an adjustment to the tax basis of your existing shares. Likewise, a stock split will cause an adjustment as well.
How to calculate an adjusted basis on an investment property
To start calculating an adjusted basis, it's important to have a clear idea of what adjustments can be made to the tax basis. We've listed them for you below.
Increases in basis
- The cost of any improvements made to the property
- Amounts spent to restore the property after damage from natural causes, like fire or flood
- Tax credits for recent home energy improvements
- The cost of adding utility fees to the property
- Legal fees used to defend your rightful ownership of the property
Decreases in basis
- Depreciation from using the home as a business or a rental property
- Insurance payouts you receive as a result of loss or theft
- Any casualty loss not covered by insurance
- Any payment you receive from granting it an easement
Calculating adjusted basis: An example
To calculate adjusted basis, you first need to know the original basis for the asset. In this case, let's assume that you bought a rental property for $200,000 cash. During the course of the transaction, you also paid $10,000 in closing costs and afterward, you made another $10,000 worth of improvements to the property. In this case, your original basis would be $220,000, or $200,000 + $10,000 + $10,000.
However, let's say that you then held on to the property for five years. Each year, you depreciated the rental property by $10,000. The total depreciation for the property is worth $50,000, which makes your adjusted basis $170,000, or $220,000 - $50,000.
The bottom line
It's important for investors to know that understanding how to calculate an adjusted cost basis will benefit them on their tax return. Having a higher basis will help you when you're ready to sell a rental property because it will reduce your amount of capital gain.
That said, if you have specific questions about basis adjustment or your tax liability, it's best to reach out to a tax professional for advice.