Capital Gains Tax

Capital appreciation results from an increase in the value of a property and is subject to capital gains tax (rather than income tax). Taxes on this equity appreciation, however, are not paid unless the property, or interest in the property, is sold. The capital gains tax rate is subject to frequent and abrupt revision by Congress. The capital gains rate influences investor willingness to buy and sell property. The higher the tax, the less likely an owner with equity appreciation is to sell. The reverse motivation exists with lower capital gains taxes.

Basis

In real estate, basis has a specialized meaning. Basis is an accounting term that describes the book value, as defined in the tax code, of a real estate investment; it is used in the calculation of capital gains tax. Basis increases with any capital improvements to the property and decreases by the cost recovery deductions taken. An understanding of basis is necessary to determine cost recovery as well as gain or loss upon the sale of a property.

There are three kinds of basis:

• Original basis (at acquisition) of a property for tax purposes is the purchase price plus any other costs of acquisition that are capitalized. Generally all costs of acquisition are added to the basis except deductible income and expense prorations (property taxes, insurance, etc.).

• Recoverable basis includes the value of improvements only. The cost of land cannot be recovered for tax purposes, so the original basis must be allocated between land and improvements (which are the recoverable basis). If a property costs $1.4 million, and the land itself is valued at $300,000, the recoverable basis is $1.1 million. Many investors prefer to allocate as much of the original basis as is legally defensible to the improvements to maximize cost recovery deductions and shelter as much income as possible.

• Adjusted basis is calculated by adjusting the original basis upward or downward over the holding period of the asset to reflect added capital improvements and subtracted cost recovery.

Since the land is not cost recoverable (i.e. not depreciable), an investor must reasonably allocate a portion of the total investment cost between the land and the improvements upon that land in order to arrive at a depreciable basis. Most investors use the taxing entities as a guideline to what percentage to assign to the value of the land versus the value of the improvements. However, if an investor can justify unusually expensive improvements relative to the land (e.g., a high-tech building in a rural area), then it may be advantageous to use a different allocation, even though it is subject to challenge by the IRS if it is disproportionate.