Why fixing a basis error matters
A correct tax basis determines how much gain or loss you report when you sell or dispose of property and how much depreciation you can claim while you own it. An incorrect basis can overstate gains (triggering excess tax), understate losses, or produce incorrect depreciation and recapture on sale. Leaving errors unaddressed can lead to higher tax bills, interest, penalties, and increased audit risk.
In my practice as a CPA and CFP®, I’ve seen clients reduce large tax liabilities simply by reconstructing a correct basis—especially for real estate and inherited property. That reconstruction often uncovered deductible costs or capital improvements taxpayers hadn’t included originally.
Quick overview of the rules you need to know
- Time limit to claim a refund: Generally file Form 1040-X within three years after you filed the original return or within two years after you paid the tax, whichever is later. See the IRS Form 1040-X guidance for details (IRS). About Form 1040-X.
- Basis guidance: The IRS explains what to include in basis and common adjustments in Publication 551, Basis of Assets. IRS Publication 551.
- If the basis error affects depreciation or an accounting method, you may need Form 3115 (change in accounting method) rather than a simple amended return. About Form 3115.
- Sales and dispositions rules: For sales where basis drives the gain or loss, see Publication 544. IRS Publication 544.
Step-by-step process to correct a basis error
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Identify the exact error. Compare the original return’s entries (Schedule D, Form 8949, Form 4797, Form 4562, etc.) against closing statements, purchase contracts, invoices, and improvement records.
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Reconstruct the correct basis. Use the IRS formula:
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Adjusted basis = cost (or inherited value) + acquisition costs + capital improvements + certain restoration costs – depreciation allowed or allowable – casualty losses previously deducted + other statutory adjustments. (Publication 551.)
Example: You bought a rental for $200,000, paid $3,000 in closing costs, made $25,000 in capital improvements, and claimed $15,000 in depreciation. Adjusted basis = 200,000 + 3,000 + 25,000 – 15,000 = $213,000.
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Assess which tax year and forms are affected. If the error changes a prior-year sale, that year’s return is typically the one to amend. If it affects depreciation taken across several years, additional steps may be required.
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Decide the correct filing vehicle:
- Individuals: Form 1040-X to amend the affected year(s) (for many corrections). Form 1040-X guidance.
- Depreciation/accounting method changes: Often use Form 3115 to request IRS consent or to make a Section 481(a) adjustment. (See IRS Form 3115 guidance.)
- Sales adjustments: Include corrected capital gain/loss reporting using Form 8949 and Schedule D as applicable.
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Prepare supporting documentation. Attach an explanation of the change, calculations, and documents that prove acquisition costs, improvements, or inherited values—closing statements (HUD/ALTA), receipts, canceled checks, contractor invoices, brokerage cost-basis reports, and estate tax valuations.
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File the amendment(s). For tax years 2019 and later, the IRS allows e-filing of Form 1040-X for many filers; older years require paper filing. Follow the instructions on the IRS site. Form 1040-X guidance.
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Track interest and penalties. If the result of the amendment reduces tax, you may get a refund. If it increases tax, you’ll owe any additional tax plus interest from the original due date and possibly penalties; however, proactively correcting mistakes can reduce penalty exposure.
Common scenarios and how to handle them
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Real estate with unreported improvements: Reconstruct direct costs (receipts/permits). If improvements should have increased basis but didn’t, amend the year of sale to reduce reported gain. Also check state return rules—state amendment deadlines differ. See our internal guide on How State Amended Return Rules Differ.
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Inherited property: Verify whether the property received a stepped-up (or stepped-down) basis at death. If you reported the wrong basis, amend the year of sale. See our primer on Basis of Inherited Property Explained.
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Investments (stocks, funds): Reconcile brokerage year-end statements and Form 1099-B. Reinvested dividends, stock splits, return of capital, and wash sales can affect basis. For ongoing tracking best practices, consult our article Best Practices for Tracking Cost Basis on Investments and Real Estate.
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Depreciation errors: If prior-year depreciation was wrong, you may need a Form 3115 or an amended return depending on whether the change is an accounting method change. A technical correction may require a Section 481(a) adjustment to spread the catch-up over the current year.
Documentation checklist (what the IRS will want to see)
- Original closing statement (HUD-1 or settlement statement) or purchase contract
- Receipts and invoices for capital improvements
- Cancelled checks, credit card statements that prove payment
- Brokerage 1099s, trade confirmations, and fund transaction histories
- Estate or trust valuations, Form 706 (if applicable) supporting stepped-up basis
- Prior tax returns and schedules showing amounts originally reported
- A clear, written explanation of the correction and the calculation leading to the new basis
Practical examples
Example 1 — Underreported improvements on a sale:
A taxpayer sold a rental in 2020 and reported a gain using a $150,000 basis. After review, they found $40,000 in improvements that weren’t included. Amending the 2020 return reduced the gain and produced a refund. The taxpayer filed Form 1040-X with receipts and the corrected Schedule D.
Example 2 — Stock basis missed an adjustment:
An investor sold shares in 2022. Their reported basis didn’t include reinvested dividends and a return of capital adjustment. Correcting the basis required amending the 2022 return with Form 1040-X and attaching corrected Form 8949 entries from the broker statements.
When not to file an amended return immediately
If you received an IRS notice explaining the adjustment, don’t file an amendment that contradicts the notice without first responding to the notice or contacting the IRS. Sometimes the IRS can be corrected directly through the contact methods in the notice.
Penalties, audits and timing to worry about
- Statute of limitations to claim refunds: usually three years from filing or two years from tax paid (whichever is later). Refer to the Form 1040-X instructions for exact language. Form 1040-X guidance.
- IRS assessment window: normally three years after a return is filed, six years for substantial understatement (more than 25% of gross income), and no statute for fraud or failure to file. (See IRS guidance in Publications and Form Instructions.)
- Filing an amendment proactively often lowers the chance of penalties and shows good faith if the IRS later audits.
Professional tips
- Keep a centralized cost-basis file (digital and backed up) for each asset: acquisition docs, improvements, depreciation schedules, and broker statements.
- If corrections affect multiple years or depreciation methods, engage a CPA or tax lawyer—these changes can trigger complex accounting-method rules requiring Form 3115.
- Don’t toss documentation. The IRS recommends keeping records for as long as they are needed to support an item on your tax return—often three to seven years depending on the issue. (IRS recordkeeping guidance.)
How we can help
In my practice, reconstructing bases often involves obtaining old settlement statements from title companies, hunting brokerage records, and creating a year-by-year depreciation worksheet. If you need help deciding whether to amend or how to prepare a Form 3115, consult a CPA experienced with basis reconstructions.
Professional disclaimer: This article is educational only and does not substitute for personalized tax advice. Tax law changes and individual facts can change the outcome—consult a qualified tax professional before filing amended returns.
Authoritative sources
- IRS Publication 551, Basis of Assets: https://www.irs.gov/pub/irs-pdf/p551.pdf
- IRS Publication 544, Sales and Other Dispositions of Assets: https://www.irs.gov/pub/irs-pdf/p544.pdf
- About Form 1040-X, Amended U.S. Individual Income Tax Return: https://www.irs.gov/forms-pubs/about-form-1040x
- About Form 3115, Application for Change in Accounting Method: https://www.irs.gov/forms-pubs/about-form-3115
Internal resources
- How to File an Amended Return (Form 1040-X): Step-by-Step Guide: https://finhelp.io/glossary/how-to-file-an-amended-return-form-1040-x-step-by-step-guide/
- Best Practices for Tracking Cost Basis on Investments and Real Estate: https://finhelp.io/glossary/best-practices-for-tracking-cost-basis-on-investments-and-real-estate/
- How State Amended Return Rules Differ: Deadlines and Limitations: https://finhelp.io/glossary/how-state-amended-return-rules-differ-deadlines-and-limitations/
If you want, I can produce a fillable documentation checklist you can use to gather records for a basis reconstruction.
