Cost basis definition
Cost basis is the asset’s purchase price, including fees and taxes, or its fair market value when inherited.
The cost basis of an asset is generally the amount paid for it, including fees, taxes, or commissions; in some cases, as with inherited property, it may be the fair market value of the asset at the time of acquisition.
Cost basis is used to calculate taxes owed on any capital gain or loss resulting from the asset’s sale.
What is the difference between cost basis and purchase price?
For most assets, the cost basis is the original purchase price plus any allowable acquisition costs, plus/minus adjustments over time. Adjustments may include improvements to or depreciation of the asset.
How is cost basis determined when selling a home?
The cost basis of a home when selling it depends on how the seller first acquired the property.
The cost basis of purchased property includes the purchase price, closing costs, settlement fees, and any improvements made, minus casualty loss and any other decreases; for self-built property, it’s the total cost of construction
The cost basis of inherited and gifted properties is generally based on the fair market value of the home at the time of the original owner’s death or of the gift. Some additional Internal Revenue Service (IRS) rules also apply to gifts.
A simplified cost basis calculation
Suppose a home was purchased for $100,000. Over the years, the owner spent $10,000 on capital improvements (capital improvements include permanent upgrades to the home, not repairs). These improvements increased the cost basis of the property because they extend the home’s useful life or increase its value.
Adjusted cost basis would be calculated as follows:
$100,000 (purchase price) + $10,000 (qualified improvements) = $110,000
If the home was later sold for $200,000, the capital gain is the difference between the sale price and the adjusted cost basis:
$200,000 (sale price) – $110,000 (adjusted cost basis) = $90,000 capital gain
This $90,000 is the amount used to determine whether any capital gains tax applies (subject to IRS rules, exclusions, and filing requirements).
The Section 121 exclusion
It’s important to note that if the home has been the homeowner’s primary residence for at least 2 of the 5 years preceding the sale of the home, the homeowner may qualify for the Section 121 exclusion, which allows individual taxpayers to exclude up to $250,000 in capital gain and $500,000 for married couples filing jointly.
The Section 121 exclusion does not reduce the cost basis. It allows you to exclude some or all of the gain from taxable income. In the example above, if requirements were met for the Section 121 exclusion, the taxpayer would not owe income tax on the capital gain.
