A property’s cost basis is most affected by an owner’s:
Audio Lesson
Duration: 2:55
Question & Answer
Review the question and all answer choices
debt service.
Debt service (principal and interest payments) are financing costs that don't affect basis. They're either deductible interest expenses or reductions of loan principal, neither of which changes the property's original cost basis.
interest expense.
Interest expense is tax-deductible but doesn't increase basis. It's an operational cost that reduces taxable income each year but doesn't modify the property's original cost basis or value.
costs of operation.
costs of improvements.
CORRECT_ANSWER
Why is this correct?
Costs of operation are deductible expenses that don't increase basis. They reduce taxable income but don't affect the property's cost basis, which starts with purchase price and is increased only by capital improvements and decreased by depreciation.
Deep Analysis
AI-powered in-depth explanation of this concept
Understanding cost basis is fundamental in real estate for tax purposes, capital gains calculations, and depreciation. This question tests the core principle that cost basis is the original value of an asset plus capital improvements minus depreciation. In California real estate practice, agents must understand this concept when advising clients on property investments, sales, and tax implications. The question distinguishes between items that affect basis (capital improvements) and those that don't (operating expenses, debt service, interest). The reasoning process involves identifying which option represents a capital improvement versus an operational expense. Option C (costs of operation) incorrectly suggests operating expenses affect basis, when in fact they are deductible expenses that don't increase basis. The challenge here is recognizing the terminology differences between what constitutes an improvement versus an expense, which is a common point of confusion for new agents.
Knowledge Background
Essential context and foundational knowledge
Cost basis is a fundamental concept in real estate taxation and accounting. It represents the total value of a property for tax purposes, starting with the purchase price and closing costs. Capital improvements that add value or extend the property's life are added to basis, while depreciation deductions reduce it. This distinction matters because it affects capital gains calculations when the property is sold. The IRS has specific guidelines for what qualifies as a capital improvement versus a repair or maintenance expense, which agents should understand to properly advise clients.
BASIC - Basis starts with purchase price, Add capital improvements, Subtract depreciation, Include closing costs
Remember this acronym when determining cost basis. Only items that increase or decrease the property's fundamental value affect basis, not ongoing operational expenses.
When asked about cost basis, remember it's only affected by capital improvements (additions) and depreciation (subtractions). Operating expenses, debt service, and interest don't change basis.
Real World Application
How this concept applies in actual real estate practice
A client is considering selling their home and asks about potential capital gains tax. As their agent, you need to calculate their cost basis. They've made several renovations over the years—adding a new roof (capital improvement), replacing windows (capital improvement), but also regular maintenance like painting and fixing leaks (repairs, not improvements). You explain that only the roof and windows increased their basis, while the painting and repairs were deductible expenses that didn't affect basis. This understanding helps determine their actual gain when calculating potential taxes.
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