Basis explained: The tax term every listing agent should understand

Not a lot of real estate agents talk about basis, and I am including myself in that group.

It is not sexy. There are no glossy photos, no bidding wars, and no champagne at closing. Basis is the unglamorous arithmetic that decides how much of your equity you keep when the tax man comes calling, and most of us avoid the topic because we (I) do not fully understand it.

I kinda of know about it. As some of you may know, a little knowledge is a dangerous thing, and a client asked me about it the other day, so I wrote an explainer, but please, you all know the drill.

I am not a CPA or a tax attorney. I am a real estate broker with a lot of time in the business and a healthy respect for people who know more than I do about the Internal Revenue Code. Before you act on anything in this column, talk to a qualified tax professional. I mean it.

Here’s why agents need to understand the concept even if they never prepare a return. When you sell a home, you are not taxed on the sale price. You are taxed on the gain, and the gain is the sale price minus your basis. Basis is your purchase price plus qualifying capital improvements. Every documented dollar you put into the house over the years can lower the number the government taxes.

A well-organized folder of receipts can be worth $50,000 or more at the closing table, as IRS Publication 523 explains in more detail than most sellers ever read. Most sellers do not have one.

This week I am answering questions I got from clients and colleagues about basis. Speaking of questions, if you have any for me or have a topic to recommend, email me.

Question: What exactly is basis, and why does it matter to me?

Answer: Basis is the number the IRS uses to measure your investment in a property. That is it. It is what you paid plus what you put into the property over the years. A higher basis means less capital gains tax liability.

Your starting basis is usually what you paid for the property, plus certain purchase costs. Over time, qualifying improvements can increase your basis. A new bedroom, a remodeled kitchen, a roof replacement, or a major system upgrade may count. Routine repairs and maintenance usually do not. The IRS draws a vivid line between capital improvements that add lasting value and maintenance that just keeps the house running.

Here is the simple math. You buy a home for $500,000 and spend $100,000 on qualifying improvements. Your adjusted basis may be approximately $600,000. Later, you sell it for $900,000 and pay $50,000 in selling expenses. Your amount realized is approximately $850,000. The initial gain calculation is $850,000 minus $600,000, or $250,000, according to IRS Publication 523.

That number matters because it helps determine whether you have a taxable capital gain and how big that gain is when the dust settles.

If the property was used as a rental, depreciation you claimed, or should have claimed, generally reduces your basis and can increase the taxable gain when you sell, according to IRS Publication 551. That is the sentence that comes back to haunt people years later. Ask me how I know.

Basis also matters when property is inherited, gifted, damaged, converted to a rental, or transferred through certain estate or divorce transactions. Those situations can have different rules, and they are the kind of thing you want to ask a CPA about before you assume anything.

Question: What counts as a qualifying improvement, and what does not?

Answer: A qualifying improvement is a permanent change that adds value to your property and extends its useful life. Those costs can increase your basis and potentially reduce your taxable gain when you sell, according to IRS Publication 523.

Examples of qualifying improvements include:

• Adding a bedroom, bathroom, deck, or garage. 
• Remodeling a kitchen or bath.
• Replacing the roof. 
• Installing or replacing plumbing, electrical, heating, or air-conditioning systems. 
• Adding insulation, storm windows, or hardscaping the yard. 
• Converting unfinished space into finished living area. 

Keep the invoices and permits with your property records; the IRS likes documentation.

Routine repairs and maintenance generally don’t increase basis; think leaking faucet, patching drywall, repainting, replacing a broken window, cleaning gutters, servicing the furnace, or repairing ordinary wear and tear, according to IRS Publication 551.

Question: What type of documentation do I need to show the IRS that I improved my property?

Answer: The IRS doesn’t expect one magical document labeled “proof of renovation”. It expects a reasonable paper trail showing what you paid, when you paid it, and what was done.

Keep these records.

• Contractor invoices and paid receipts
• Contracts, proposals and change orders
• Canceled checks, credit-card statements or bank records
• Building permits, inspection reports and final approvals
• Architect, engineer and design invoices
• Before-and-after photographs
• Material receipts for work you did yourself

The strongest evidence connects the improvement to the property and shows actual payment. A photograph of a beautiful new kitchen proves nothing about cost.

The IRS requires accurate records of anything that affects basis. Improvements generally increase basis. Your own labor does not count, and unpaid work cannot be added to basis, according to IRS Publication 551.

Keep the records as long as you need them to establish adjusted basis and calculate gain or loss when you sell.