How Adjusted Basis Works

A considerable change in the original recorded cost of a property or security after you have sold it is an adjusted basis. You will normally compute the capital gain or loss on a sale for tax purposes by modifying the initial purchase cost to accommodate for any gains or declines in its value. In general, a modification that raises the cost basis reduces your tax liability. The adjusted basis differs from the unadjusted basis because the latter does not consider any changes in the cost over time.

The original recorded value you paid to acquire an asset or investment, including any commissions, associated taxes, and other fees, is the cost basis. Events might occur over the period of ownership, like installing new features, spending money on renovations, ordinary wear and tear, or capital expenditures (CAPEX), that might increase or decrease this basis.

In such circumstances, you must change the amount you paid in order to keep accurate gain and loss records for the sake of tax calculations and return calculations. When you decide it is time to sell the property or investment, the adjusted basis is what you will utilize to determine if a capital gain or loss has occurred.

Example of Adjusted Basis

Let's say you acquire a $150,000 house for $25,000 cash and a $125,000 mortgage. Start with $150,000 and add any additional costs, such as if you had to pay real estate taxes the former owner owed that you paid as part of the transaction, to arrive at the basis. Whatever figures you get is your basis.

Add or remove any associated credits or costs to have your adjusted basis. If you paid out $50,000 on home upgrades, for instance, add $50,000 to the basis you arrived at earlier to get a new adjusted basis of $200,000. If a flood-damaged your home and you had to spend an additional $5,000 for repair work, include this to your adjusted basis to get $205,000. Make sure to determine the depreciation of your rental property before selling it.

Significance of Adjusted Basis

When you or your business possesses an asset, like a piece of heavy machinery or a building, you can claim depreciation for wear and tear. The cost basis of your asset changes as you claim depreciation. On the other hand, improvements to an asset can lead to a reassessment of cost basis and a basic modification.

When specific events occur, it may modify the cost basis of your security, such as shares of stock. A dividend a company pays in additional stock, for example, will result in a change in the cost basis of the original shares. In the instance of a stock split or a capital distribution, the original share's cost basis will change as well. Dividends given in cash by the issuing corporation do not affect the adjusted basis.