What Is Cost Basis in Real Estate? How It Affects Depreciation and Taxes at Sale

Cost basis is the invisible number that determines your tax bill in almost every rental property transaction. Every time you take a depreciation deduction, you lower your basis. Every capital improvement raises it. Get the basis wrong, and you either overpay taxes or underreport income — neither is good.

What's Included in Your Initial Basis

• Purchase price: The contract price paid for the property
• Closing costs: Title insurance, recording fees, attorney fees, transfer taxes paid by the buyer
• Broker commissions: Commissions paid in connection with the acquisition
• Prepaid items capitalized: Some prepaid expenses at closing may be added to basis
• NOT included: Points paid to obtain a mortgage (deductible separately), prorated property taxes (deductible currently), homeowner's insurance

How Depreciation Reduces Your Basis

Each year you take a depreciation deduction, your adjusted basis decreases by the same amount. After 10 years of $16,000/year in depreciation on a $500,000 property, your adjusted basis is $340,000 ($500,000 − $160,000 depreciation taken). If you sell for $600,000, your gain is $260,000 ($600,000 − $340,000), not $100,000 ($600,000 − $500,000).

Critically, the IRS reduces your basis by depreciation 'allowed or allowable' — meaning they reduce it whether or not you actually claimed the deduction. If you forgot to take depreciation for several years, your basis is still reduced — and you owe recapture tax on deductions you never took. This is why it's always better to take depreciation and file Form 3115 for any missed years.

How Cost Segregation Affects Basis

Cost segregation accelerates basis reduction. Instead of $16,000/year over 27.5 years, cost seg generates $130,000+ in year one. Your adjusted basis drops $130,000 in year one alone. This is why large cost segregation deductions taken early in ownership create a potentially large recapture liability if you sell shortly after.

The solution: hold the property long enough that the time value of the early deductions outweighs any recapture at sale — or use a 1031 exchange to defer recapture indefinitely when you're ready to sell.