How to avoid confusion with basis adjustments
By Cora M. Barnhart • Bankrate.com

Oct. 14, 1999 -- Capital gains intimidate homeowners and business people alike. But grappling with the gain isn't nearly as taxing as knowing what values to plug into the computation.

Many mistakes in this area stem from misperceptions related to a property's original basis, and then how to adjust it.

In the simplest case, when someone buys a property, the amount paid determines the basis. This includes most settlement or closing costs paid, plus any debt assumed. If the buyer built a structure on the property, the basis includes settlement or closing costs of acquiring the lot and securing the mortgage. A related tax tip describes the other methods by which original basis is determined.

The basis adjusts over time, and taxpayers should keep a close eye on that number if they don't want to lose money.

Selling a home or exchanging property for a share in a business are two examples of times when keeping up with this value is important. This tax tip helps homeowners and future partners alike understand what causes the basis in a property to increase or decrease.

Improvements increase home basis
Enhancing a property is the most common reason a property's basis increases. Home improvements are a good example of this. Property owners should exercise discretion in this area, though, because the IRS can get picky over what it will accept as an improvement.

The agency insists that an improvement accomplish one of three goals:

• Make the property more valuable.
• Make it last significantly longer.
• Make it appropriate for new uses.

Do-it-yourselfers need to keep in mind that they can only add whatever costs they actually incur for improvements to their home's basis. While backbreaking labors may increase your back pain, you can't add this cost of the fruits of your labor to the basis of your property.

The table at left contains some common examples of improvements.

Other adjustments to basis
Property owners can do a number of other things that will increase or decrease a property's basis. For instance, restoring a damaged property increases its basis.

There are a number of common reasons that a property's basis will decrease. The basis decreases if the owner is reimbursed for a casualty loss or if he deducts casualty losses that aren't covered by insurance. It will also decrease if the owner receives a payment for an easement, claims depreciation for use in business or defers a gain on a sale of a previous residence.

Two additional points to keep in mind
Taxpayers calculating a property's basis need to remember two other important details about improvements.

First, any improvement that is reported must remain with the property when it is sold. This means a property owner can't claim the same expense twice. For example, if you replace a water heater more than once, you may only add the cost of the latest expenditure to basis.

Second, the IRS distinguishes between an improvement and a repair. A repair keeps a property in an ordinary and efficient operating condition. The IRS doesn't treat repairs the same as improvements. Repairs don't add value to a property, prolong its life or adapt it to a new use. Bottom line? You can't add the repair cost to a property's basis.

However, there are ways to get around this. Careful timing and luck can transform a repair into a property improvement. Completing repairs while extensively remodeling a home, for instance, means the IRS will consider them as improvements. They can be added to your basis.

Also, it isn't always easy to distinguish between an improvement and a repair. For example, painting either a room or your entire house for the first time is an improvement, meaning the cost can be added to basis. A later repainting of the room or entire house is a repair, and this cost doesn't increase your basis.

-- Posted Oct. 14, 1999