Why It Matters
Here's what matters. Formula: Adjusted Basis = Purchase Price + Capital Improvements − Accumulated Depreciation. Lower basis means higher taxable gain. Every year of depreciation drops your basis by that year's deduction. The "allowed or allowable" rule makes this unforgiving: even if you forgot to claim depreciation, your basis is reduced by the amount you could have claimed — you pay recapture tax on deductions you never received. In a 1031 exchange, your adjusted basis carries into the replacement property instead of resetting to the new price, deferring the gain but carrying the liability forward.
At a Glance
- Starting point: Purchase price plus all acquisition costs paid by the buyer — title insurance, recording fees, transfer taxes paid by buyer, attorney fees
- Increases basis: Capital improvements only — new roof, HVAC replacement, addition, full kitchen renovation that adds value; repairs and maintenance do not add to basis
- Decreases basis: Depreciation claimed (or "allowed or allowable"), casualty loss deductions, insurance reimbursements received for property losses
- At sale: Taxable Gain = Sale Price − Selling Costs − Adjusted Basis; the depreciation portion is recaptured at up to 25%, the remainder taxed as long-term capital gain
- 1031 exchange: Replacement property inherits the relinquished property's carryover basis — it does not receive a fresh step-up to the new purchase price
Adjusted Basis = Purchase Price + Capital Improvements − Accumulated Depreciation
How It Works
Building the initial basis. Starting basis is purchase price plus acquisition costs you paid: title insurance, transfer taxes, attorney fees, recording fees, survey. What does NOT count: seller-paid closing costs, prepaid mortgage interest, loan points — those are deductible items, not basis-builders. Every dollar correctly added to initial basis reduces taxable gain at sale.
How depreciation erodes basis. Each year you depreciate the building, your adjusted basis drops by that year's 27.5-year depreciation amount. A property at $380,000 with $76,000 in land has a $304,000 depreciable base — $11,054/year. After 10 years: $110,540 claimed, adjusted basis now $269,460 ($193,460 building + $76,000 land). Sell for $500,000 with $18,000 in costs: taxable gain is $212,540. Of that, $110,540 is §1250 recapture taxed at up to 25% and $102,000 is long-term capital gain — the recapture piece entirely driven by how much depreciation shrank the basis.
1031 exchange carryover basis. When you execute a 1031 exchange, you carry your low adjusted basis into the replacement property — it does not reset to the new purchase price. A $269,460 basis on a relinquished property becomes the starting point on a $750,000 replacement (adjusted for boot and mortgage changes). After multiple exchanges, the carryover basis can be far below market value — the gain defers but accumulates. The basis only steps up to market value when the final property passes through an estate.
Real-World Example
Rachel bought a triplex in 2016 for $285,000. Acquisition costs added $4,200, bringing initial basis to $289,200. Over 8 years she completed three capital improvements: new roof ($18,500), HVAC ($11,200), bathroom remodels ($9,800) — $39,500 added to basis. She also claimed 27.5-year depreciation on $231,360 of building value: $8,413/year × 8 years = $67,304.
Adjusted basis at sale in 2024: $289,200 + $39,500 − $67,304 = $261,396. Sells for $465,000, $21,000 in selling costs. Taxable gain: $465,000 − $21,000 − $261,396 = $182,604. Of that, $67,304 is depreciation recapture taxed at up to 25% and $115,300 is long-term capital gain. The documented improvements alone reduced her tax bill by roughly $7,900.
Pros & Cons
- Every documented capital improvement permanently reduces taxable gain at sale — the record-keeping pays off directly at closing
- Knowing your current adjusted basis lets you model the tax cost of selling versus exchanging before committing
- Accurate basis tracking makes recapture predictable — you know what portion of the gain will be taxed at the §1250 rate before you commit to selling
- Carryover basis in 1031 exchanges is manageable with clean records — embedded gain is calculable at any point
- Stepped-up basis at death eliminates accumulated gain for heirs, making long-term holds valuable for estate planning
- Basis errors compound: a missed improvement in year 2 skews every calculation for the next 20 years and inflates the tax bill at sale
- The "allowed or allowable" rule is unforgiving — forgotten depreciation still reduces basis, so you pay recapture tax on deductions you never received
- Multiple 1031 exchanges create layered basis chains from decades-old acquisitions that may be hard to reconstruct
- Some states reject accelerated depreciation, requiring a separate state-adjusted basis calculation
- Partial dispositions require basis allocation most investors skip, overstating gain at sale
Watch Out
Capital improvements versus repairs. Repairs — painting, patching drywall, fixing a leak — are expensed in the year incurred and do not add to basis. Capital improvements — new roof, foundation work, kitchen renovation that adds value — are not expensed; they are added to basis and reduce your eventual gain. Misclassifying an improvement as a repair means you got a deduction today but forfeited the basis increase, and that overpayment at sale is often far larger than the deduction you claimed.
Depreciation reduces your basis whether or not you claimed it. The "allowed or allowable" rule: forget to claim 5 years of depreciation, your basis is still reduced by the full amount you could have claimed. You owe §1250 recapture on deductions you never received. Fix: Form 3115 filed before sale catches up all missed depreciation at once. Paying recapture on unclaimed deductions is avoidable — Form 3115 prevents it.
Track improvements with receipts from day one. The IRS can require documentation for every capital improvement added to basis. Permit records, contractor invoices, and bank statements are your proof. A property held 15 years accumulates dozens of projects. Without records, your CPA cannot add those amounts to basis and you overpay at sale. A folder per year — physical or digital — with receipts and permits takes five minutes per project and can be worth thousands at exit.
Ask an Investor
The Takeaway
Tax basis is the foundation of every sale calculation — built or eroded across the entire hold period. Capital improvements increase it; depreciation decreases it; both run simultaneously. The record-keeping obligation is entirely yours. Investors who track basis carefully go into sale negotiations with a clear picture of their actual exposure and their recapture liability. Those who do not face an unpleasant number at closing when the gain runs against a basis far lower than expected. The cost basis adjustment process is not complicated — it just requires discipline from closing day forward.