Cost Basis at Purchase

Your cost basis is the total amount you're considered to have invested in the property for tax purposes. It's established when you buy and affects both your annual depreciation deduction and your taxable gain when you sell.

What's Included in Cost Basis

Added to basis:

Purchase price
Closing costs (title insurance, escrow fees, recording fees)
Legal fees, survey & title search
Transfer taxes

Not added to basis:

Loan costs (origination fees, points) → amortized over loan term
Prepaid items (property taxes, insurance escrow) → deducted as operating expenses

Example: Cost Basis Calculation

Purchase Price: $300,000 Closing Costs Added to Basis: Title Insurance: $1,200 Escrow Fees: $500 Recording Fees: $150 Attorney Fees: $800 Transfer Taxes: $1,500 ────────────────────────────────────────────── Total Added to Basis: $4,150 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ TOTAL COST BASIS: $304,150 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

Why it matters: A higher cost basis means larger depreciation deductions during ownership and a smaller taxable gain when you sell.

Deductible Costs During Ownership

Each year, you can deduct ordinary and necessary expenses from your rental income.

What's Deductible

Deducted in full each year:

Operating expenses (mortgage interest, property taxes, insurance, management fees, advertising)
Repairs (fixing leaks, repainting, replacing broken items)

Deducted over 27.5 years:

Depreciation¹ → building value ÷ 27.5 per year
Improvements → improvement cost ÷ 27.5 per year (new roof, HVAC, renovation)

¹ Only the building portion can be depreciated, not land.

Example: Annual Deductions

Rental Income: $30,000 Deductible Expenses: Mortgage Interest: $15,000 Property Taxes: $4,500 Insurance: $1,500 Property Management: $3,000 Repairs: $1,200 Depreciation¹: $8,800 ────────────────────────────────────────────── Total Deductions: $34,000 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ NET RENTAL INCOME (LOSS): ($4,000) ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

¹ Depreciation is a non-cash expense. This $4,000 "paper loss" may occur even when the property has positive cash flow.

Passive Loss Rules

Rental losses are passive losses. Whether you can deduct them against your wages depends on your income:

Can you deduct rental losses against wages?

If Real Estate Professional (750+ hours):

Yes, unlimited

Otherwise, if actively participating¹:

MAGI under $100k → Yes, up to $25,000/year
MAGI $100k–$150k → Partial (phases out)
MAGI over $150k → No (losses are suspended)

Otherwise:

No (losses are suspended)

¹ Active participation means making management decisions (approving tenants, setting rent, approving repairs). Using a property manager doesn't disqualify you.

What happens to losses you can't deduct?

They're suspended (not lost) and can be used later to:

Offset passive income from other rentals or businesses
Offset gain when you sell the property

Example (based on assumed investor profile with $300k income)

YEAR 1: Loss gets suspended ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Rental Loss (Property 1): $8,000 MAGI: $300,000 (over $150k) Deductible Against Wages: $0 → Suspended: $8,000 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ YEAR 2: Use suspended loss against passive income ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ You buy Property 2, which generates income. Property 2 income: +$10,000 Property 1 loss: -$4,000 Net passive income: +$6,000 Using suspended loss: Year 1 suspended: $8,000 Used to offset income: -$6,000 Taxable passive income: $0 Still suspended: $2,000 (carries forward) ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

Calculating Gain at Sale

When you sell, your taxable gain is calculated using your adjusted basis, which accounts for depreciation taken during ownership.

Adjusted Basis Formula

Original Cost Basis + Capital Improvements Made − Depreciation Taken (or allowed) ──────────────────────────────── = Adjusted Basis

Example: Adjusted Basis Calculation

PURCHASE (Year 0): ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Purchase Price: $300,000 Closing Costs: $4,150 Cost Basis: $304,150 DURING OWNERSHIP (5 Years): ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Annual Depreciation: $8,727 (Building value¹ $240,000 ÷ 27.5 years²) Total Depreciation (5 years): $43,635 Capital Improvement (new HVAC): $8,000 AT SALE (Year 5): ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Original Cost Basis: $304,150 + Capital Improvements: $8,000 − Depreciation Taken: ($43,635) ──────────────────────────────────────────────── ADJUSTED BASIS: $268,515 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

¹ Building value = only the structure, not land (you cannot depreciate land). In this example: $300,000 × 80% = $240,000.

² 27.5 years is the IRS-mandated depreciation period for residential rental property.

Calculating Taxable Gain

Sale Price: $380,000 − Selling Costs (6% commission, etc.): ($22,800) ──────────────────────────────────────────────── Net Sale Proceeds: $357,200 Net Sale Proceeds: $357,200 − Adjusted Basis: ($268,515) ──────────────────────────────────────────────── TOTAL TAXABLE GAIN: $88,685 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

How Your Gain is Taxed

Your total taxable gain is split into two portions:

Depreciation Recapture (taxed at 25%¹): The portion attributable to depreciation taken
Capital Gain (taxed at 15% for assumed investor): The remaining gain

¹ The 25% rate is fixed by the IRS for unrecaptured Section 1250 gain—it doesn't depend on your income bracket.

GAIN FROM SALE: $88,685 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ TAX ON GAIN (before suspended loss benefit): Depreciation Recapture: $43,635 × 25% = $10,909 Capital Gain: $45,050 × 15% = $6,758 ───────────────────────────────────────────────── Total Tax on Gain: $17,667 SUSPENDED LOSS BENEFIT (separate deduction): Suspended Losses: $20,000 Tax Savings (at 24% marginal rate): -$4,800 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ NET TAX AT SALE: $12,867 ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Effective Tax Rate: $12,867 / $88,685 = 14.5%

Important Notes:

You always pay depreciation recapture—even if you didn't claim depreciation (the IRS taxes depreciation "allowed or allowable"). Always take your depreciation deductions!
Suspended losses provide a separate tax benefit—they don't reduce the depreciation recapture amount.

Complete Example: 5-Year Investment

5-YEAR INVESTMENT SUMMARY ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ PURCHASE: Purchase Price: $300,000 Closing Costs: $4,150 Cost Basis: $304,150 DURING OWNERSHIP (5 Years): Cumulative Rental Losses: $20,000 All suspended (MAGI over $150k) AT SALE: Total Taxable Gain: $88,685 Tax on Gain: Depreciation Recapture (25%): $10,909 Capital Gain (15%): $6,758 ──────────────────────────────────────────── Total Tax on Gain: $17,667 Suspended Loss Benefit: $20,000 × 24% = -$4,800 ────────────────────────────────────────────── Tax Due at Sale: $12,867 Effective Tax Rate: 14.5% ($12,867 / $88,685) ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━

Key Rules to Remember

Cost basis includes purchase price plus capitalizable closing costs — document everything at closing
Depreciation is mandatory — take it or lose it, you'll pay recapture tax either way (25%)
Passive loss deductibility depends on your situation — RE Professional (unlimited), active participant under $150k MAGI (up to $25k), otherwise suspended
Suspended losses aren't lost — they offset passive income or become fully deductible at sale
Capital gains get favorable rates — long-term rates are lower than ordinary income rates

Rental Property Tax Guide: Depreciation, Deductions & Capital Gains

Assumptions Used in Examples