An adjusted basis is an important tax and accounting term because it is used to determine the taxable portion of profit from selling property. Your basis can be thought of as the amount of your property investment that is considered for tax purposes. Rather than simply subtracting your purchase price from your later sales price to determine the capital gain that will be taxed, you are allowed to figure your gain based on an adjusted basis, which can reduce your tax liability.
The adjusted basis is determined by taking the original acquisition cost of a property, then applying the following adjustments to calculate a new basis that is higher or lower than the original purchase price:
*Capitalized closing costs, which increase the basis.
*Depreciation, which decreases the basis.
*Capital improvements, such as a new roof, which increase the basis.
Once these adjustments are tallied and applied to the original price or basis, you have the adjusted basis. The difference between this adjusted basis and the eventual sale price of the property will give you the portion of the sale’s profit that is taxable, also referred to as your gain or loss.
You buy a $300,000 vacation home. You make $25,000 worth of improvements to your property. Your basis is adjusted upward. But, later you end up taking a deduction for a casualty loss of $10,000. Your basis is adjusted downward. It is your adjusted basis, $315,000 that is then used to calculate your profit for tax purposes when you sell the property for $425,000. Rather than taxing a profit of $125,000 your adjusted basis leaves a taxable profit of just $110,000.
Why is it important?
Not only is it important to understand how to determine adjusted basis for the purpose of completing your taxes, but it can also help you evaluate potential property purchases. How? If you are considering several properties for investment, you can estimate your adjusted basis between the date of purchase and some anticipated future date of sale, then consider what adjustments you are likely to make for each property. Evaluate each according to how these adjustments will affect the portion of your profit that will be taxed.