No one likes talking about taxes, especially regarding taxes on hunting and fishing land. However, whether anyone likes it or not, the IRS wants its share of the profit whenever someone sells land. Understanding cost basis of property comes into play because it can directly affect the amount of tax paid later on home and land sales.
We contacted Paul Neiffer, who retired from a career with Clifton Larson Allen, one of the ten largest CPA firms in the United States, for clarification on cost basis. Neiffer frequently teaches new CPAs on farm taxes. He also runs a Farm Report blog and has a column with Top Producer magazine. It would be him if anyone knew how to break down cost basis clearly.
With that in mind, these are the most important things for any landowner to know about understanding the concept of cost basis.
What is Cost Basis?
When you purchase a property, the cost basis is the total amount you pay, which includes the property’s price, closing costs, title insurance, and other fees. The IRS uses this cost basis to calculate capital gains tax if you sell the property later. The difference is subject to capital gains tax if the sale price exceeds the original purchase price.
“It’s just simply what you paid for the property, including closing costs,” Neiffer said. “But it also includes any improvements that you put on it before you sell.”
Anything that affects a property’s value, either positively or negatively. In most cases, landowners focus mainly on improvements.
In summary, this ensures that landowners don’t pay taxes on the original price they already paid for the property when they sell it. Only any profits that might be made from a sale. With the price of real estate continuing to climb, more capital gains taxes are being paid, even on smaller lots.
Why Understanding Cost Basis is Important for Landowners?
By understanding cost basis, landowners can potentially reduce their capital gains tax, thereby maximizing their profits from a land sale.
Neiffer emphasized that cost basis is particularly significant for anyone with an income-producing property. This includes farmers, ranchers, and other small business owners who can potentially reduce their annual income tax through asset depreciation or tax credits for specific improvements.
“The reason it is important is if, and when they (landowners) sell the property, they’re allowed to deduct the cost basis, and if they don’t know what the cost basis is, they’re going to have extra income to report that they have to pay taxes on,” Neiffer said.
It’s as simple as that. Keeping tabs on cost basis over the years can save some unexpected headaches from a huge tax bill when a property finally goes up for sale. Even if you never plan to sell, Neiffer said keeping track is not a bad idea, especially if you ever anticipate using the land to produce income.
What Can Be Included in Cost Basis of Property?
Anything that increases or reduces the value of a property. In most cases, landowners will be looking primarily at improvements. These can include home renovation repairs, such as a bathroom or kitchen remodel, and additions, such as a well, barn, shed, or fence. Things done to improve a property will increase its cost basis. Adding permanent blinds, elevated tree stands, or digging a duck pond are all considered improvements for hunters and anglers.
However, the cost basis can also decrease through property depreciation over time. Neiffer said buildings usually depreciate over about 20 years, wells over 15 years, and fences around seven. It varies depending on what’s on the land.
In addition to the usual wear and tear, the cost basis can also decrease with losses paid out by insurance. For example, a payout for a flooded basement or a roof damaged by hail can be subtracted from the cost basis.
Landowners can also utilize tax credits to make improvements without increasing the cost basis. One of the more common ones is a renewable energy tax credit for installing solar panels on a property.
How Does the IRS Verify Cost Basis?
Neiffer says the IRS won’t verify cost basis unless the landowner is being audited. When the IRS does this, it expects the landowner to have the original documentation—that means deeds, sales documents, receipts, and other records. It’s probably a good idea to keep all receipts and documents dealing with property improvements, and insurance claims too.
“You always want to keep the closing statements on the purchase and the sale,” Neiffer said. You always want to keep the closing statements on the purchases until you sell the property.”
The fundamentals of the farm example apply to homeowners with smaller lots as well, though the improvements and deductions may differ.
While he recommends keeping all documentation as long as possible, he says landowners should keep it for at least three years after a sale. This is because the IRS has about three years after the year of sale to audit the tax return.
How To Calculate Cost Basis
While understanding cost basis may seem complicated, getting at least a rough idea before a sale is simple. We still highly recommend consulting a financial advisor before a sale to find every increase, deduction, and depreciation ahead of time. After all, the cost basis affects how much tax is paid on the sale. Most people want to keep that as low as possible.
As a generalized example, imagine a small farm initially purchased by the landowner for $350,000. While living there, the farmer invests an additional $50,000 for improvements such as a storage shed, fencing for livestock, and a ditch for irrigation. That would make the cost basis $400,000.
However, farming is never that simple. One summer drought destroys some of the crops. The farmer gets a $30,000 payout from insurance to cover the losses. This payment is deducted from the cost basis, dropping it to $370,000. Whenever additions and deductions are made to a cost basis, the final amount is often called an adjusted cost basis. In the example above, the farmer would pay taxes on capital gains of $130,000 from the sale of his farm for $500,000. Just subtract the adjusted cost basis from the final sale price to find the adjusted cost basis.
The basics of the farm example are the same for homeowners on smaller lots, just with different improvements and deductions. Installing a new kitchen would increase the cost basis, while a payout from insurance for a hail-damaged roof would decrease it.
This example doesn’t account for depreciation. Neiffer said almost anything non-land-related on the property can be depreciated. He said a full-blown appraisal isn’t necessary for determining the value of the assets. However, a real estate agent can help get an idea of the current value of these types of assets.
“If there’s more than just land on the property, we have to allocate cost to each of those assets,” Neiffer said.
Final Thoughts
Property values keep rising, so there will likely be some profit from the original purchase price. While it is extra work, a little planning now can save many tax headaches later, especially if audited after a sale. We highly recommend contacting a financial consultant to help determine your property’s exact cost basis. No one likes paying more taxes than needed. Thus, anyone planning to sell their land should keep track of their cost basis, even if they anticipate a sale years later.