Basis

Key Takeaways

• Cost basis is what a taxpayer has invested in a property: the purchase price plus the settlement fees and closing costs of buying it.
• Capital improvements are added to basis and depreciation is subtracted from it, and the running total is called adjusted basis.
• Gain on a sale is the sale price minus adjusted basis, so every documented dollar of basis is a dollar of gain that is not taxed.
• Washington's real estate excise tax is measured on the selling price rather than on gain, so basis does not reduce it (RCW 82.45.060).

What It Means

Basis is the figure the tax code uses to measure what an owner has put into a property. Cost basis starts with the purchase price and adds the settlement fees and closing costs of buying, so a $455,000 purchase with $6,200 in qualifying settlement charges carries a cost basis of $461,200. IRS Publication 551 treats those buying costs as part of basis, though it excludes charges connected with getting the loan.

Basis does not stay still. Capital improvements, meaning work that adds value or has a useful life of more than one year, are added to it. Depreciation deducted on an investment property, or that could have been deducted, is subtracted from it. The running total after those adjustments is adjusted basis, and adjusted basis is the number that matters on the day the property sells.

The reason to track it is the gain calculation. Sale price minus adjusted basis is the Capital Gain the seller may owe federal tax on. Every dollar of basis an owner can document is a dollar that is not taxed as profit, which is why the settlement statement and the receipts for a new roof are worth keeping for as long as the property is held.

How It Works in Washington

In Washington, basis drives a federal calculation, and the state's two relevant taxes treat it very differently. Washington's capital gains excise tax, chapter 82.87 RCW, does not reach the sale of real estate. RCW 82.87.050 exempts all real estate transferred by deed, real estate contract, judgment or other lawful instrument that transfers title to real property and is filed as a public record with the county where the property is located. A homeowner selling a Washington house measures gain against basis for the federal return, and the state capital gains tax has nothing to say about that sale.

What Washington does impose is the Real Estate Excise Tax under chapter 82.45 RCW, and it ignores basis entirely. RCW 82.45.060 imposes an excise tax upon each sale of real property measured by the selling price, at a state rate of 1.1 percent up to $500,000, 1.28 percent above $500,000 through $1.5 million, 2.75 percent above $1.5 million through $3 million, and 3 percent above $3 million, with a flat 1.28 percent on timberland and agricultural land. RCW 82.45.080 makes the tax the obligation of the seller. A seller with a high basis and a thin gain owes the same excise tax as a seller with a low basis and a large one, because the base is the price and not the profit. Chapter 82.46 RCW lets a county or city add a local excise tax on top of the state rate, so the combined bill in a given city runs higher than the state figures alone.

Example

The Nguyens buy a Vancouver house for $455,000 and pay $6,200 in qualifying settlement and closing costs, so their cost basis is $461,200. Four years later they add a bedroom and bathroom for $38,000, a capital improvement, which lifts their adjusted basis to $499,200. They then sell for $640,000.

Two calculations run off that sale and only one of them uses basis. Federal gain is $640,000 minus the $499,200 adjusted basis, which is $140,800 before selling expenses. Washington's excise tax ignores all of that: at the state rate, the first $500,000 of the $640,000 price is taxed at 1.1 percent for $5,500, and the remaining $140,000 at 1.28 percent for $1,792, giving $7,292 in state excise tax owed by the Nguyens as sellers, before any local excise tax. Now suppose they had never tracked the $6,200 in closing costs or the $38,000 addition. Their reported gain would be $640,000 minus $455,000, which is $185,000, and they would pay federal tax on $44,200 of profit they never made. Their excise tax bill would not change either way.

Common Mistakes and Exam Traps

• Basis is not market value. Market value moves with the market, while basis records what the owner paid and invested.
• Repairs do not add to basis. Capital improvements with a useful life of more than one year do, and deductible incidental repairs or maintenance do not.
• Depreciation reduces basis whether or not the owner claimed it. IRS Publication 551 requires the basis reduction for depreciation deducted or that could have been deducted.
• Washington's real estate excise tax is calculated on the selling price, not on the gain, so a large basis does not shrink the excise tax bill.