Some of you may have read my earlier post I wrote on depreciation recapture. I got several comments after the post asking for a translation. Seems I got caught up speaking in that foreign language of IRS codes and provided no cipher.

To help you better understand depreciation recapture, I’m going to explain three key concepts so that you can better understand how it affects taxes paid. These three concepts are:

Basis / Adjusted Basis in property

Gain on Sale

Depreciation recapture related to the gain

Original Basis

I’ll start with defining basis. Basis is IRS double-speak for what you paid for a property. Of course it’s not as simple as what you agreed to pay the seller. There are a few fees associated with your purchase that the IRS considers part of the cost or basis of the property. Typically these are related to title transfer. Also investors sometimes have out-of-pocket costs that may be related to a purchase.

Loan related fees and escrow payments do not add to the basis of real estate.

EXAMPLE 1: Determining original basis

Investor purchased an out-of-state property. The investor paid $400 to travel to the property that was actually purchased a few weeks later.

The investor agreed to purchase the property for 125,000.

Closing Costs

Origination Fee $1,250
Appraisal 400
Recording Fee 25
Title insurance 600
Survey fee 200

The investor’s basis

125,000 + 400 + 25 + 600 +200 = 126,225

Adjusted Basis

At the time of sale there are a number of adjustments that must be made to the original basis. For instance, an investor may have improved the property. Depreciation is a also necessary adjustment.

EXAMPLE 2: Adjusted Basis

Let’s use the example above.

Original basis $126,225
3 years depreciation $11,475
Kitchen remodel 6,500

Adjusted basis is

126,225 + 6500 – 11,475 = 121,250

Next week, I’ll discuss how the gain on sale is determined. In order to understand depreciation recapture it is necessary to have a good understanding of basis and how any gain is determined.