Whether you live in a popular residential market like Seattle, San Francisco or New York, or have simply lived in the same home for several decades, it’s more common than ever that households are incurring taxable gains when they sell their home.
Taxable gains from the sale of a primary residence occur when the gain from the sale is above the $250,000 gain exclusion for an individual and $500,000 for a couple. This gain exclusion is available to households that meet the following criteria:
- You’ve used the home as your primary residence for two out of the past five years (use test).
- You’ve owned the home for two out of the past five years (ownership test).
- You did not use the home sale exclusion in the past two years.
The gain is calculated by subtracting selling expenses and your adjusted cost basis in the property from the sale price. The adjusted basis is what you previously paid for the home plus the cost of improvements. Since you are subject to federal capital gains taxes, state taxes (where applicable) and the 3.8% Medicare surtax (in many cases as the taxable gain can be sizeable), keeping track of your improvement history can lead to significant savings on your taxes.
What’s considered an improvement?
The IRS provides the following examples of common improvements to your home that will increase your basis.
What’s not considered an improvement?
Repairs as described in the next section can be included in your improvements if they’re done as part of an extensive remodeling or restoration job. The IRS provides the following example: “replacing broken windowpanes is a repair, but replacing the same window as part of a project of replacing all the windows in your home counts as an improvement.”
The IRS provides the following examples of repairs and maintenance to your home that can’t be included in your adjusted basis:
- Any costs of repairs or maintenance that are necessary to keeping your home in good condition, but don’t add to its value or prolong its life. Examples include painting (interior or exterior), fixing leaks, filling holes or cracks or replacing broken hardware.
- Any costs of any improvements that are no longer part of your home (for example, wall-to-wall carpeting that you installed but later replaced).
- Any costs of any improvements with a life expectancy, when installed, of less than one year.
What can decrease my basis?
The following can decrease the basis in your home:
- Exclusion from income of subsidies for energy conservation measures
- Casualty or theft loss deductions and insurance reimbursements
- Postponed gain from the sale of a home
- Alternative fuel vehicle refueling property credit (Form 8911)
- Residential energy credit (Form 5695)
- Depreciation and section 179 deduction (see below for more on this topic)
- Nontaxable corporate distributions
- Certain canceled debt excluded from income
- Adoption tax credits
What are some record keeping options?
Whether requested by a potential buyer, filing your personal tax return the year of the sale, or by the IRS in an audit, it’s important to have proper documentation of all your improvements that impact your basis. This includes copies of purchase orders, receipts, canceled checks and any other documentation. Make a special folder for this purpose and keep a running a total of your improvement history. Like other important financial records, it’s recommended you also keep a digital copy of this information. If possible, scan all documentation to a secure storage site like a Box or Google Drive. At a minimum, keep a digital copy of your running total (such as a spreadsheet) so that you won’t be put into a position of having to recreate your improvement history from scratch one day.
Keep these records as long as you own the home. It’s recommended that you keep all improvement-related records for at least three years after you file your tax returns for the year of sale. There are several homeowner’s record keeper books available on Amazon.com or at your local bookstore that can help you organize and keep track of these expenses.
Note: Make sure to keep your own copies of these records rather than relying on others to keep track of them for you. Many companies and professionals purge records more than 10 years old and/or can lose track of them over time.
What if I sold my previous home pre-1997?
Prior to 1997, you could defer realizing a gain on the sale of your home by subsequently buying a home of equal or greater value. Individuals 55 or older also were eligible to use a once-in-a-lifetime $125,000 gain exclusion on their home if they bought a home of lesser value after triggering a gain. Post-1997 home sales were no longer subject to these rules (not able to defer the gain) and instead receive the more favorable gain exclusion as described above.
If you sold your previous home before mid-1997 and delayed paying the tax on any gain at the time by carrying forward your basis into your existing property, that basis impacts your home’s basis. This means that you need to have proper records to prove your previous home’s basis as well, especially since the gain may be much larger making your gain taxable.
What if I depreciated any part of my property as a rental or home office?
Any depreciation previously taken on your tax return, whether for your primary residence being a rental (at one point or another) or a home office (business purposes) needs to be recaptured when you sell your property. This means the amount of depreciation taken to offset prior years’ income won’t be shielded by the gain exclusion, and instead will be taxed at a rate of up to 25%. The technical term for this is unrecaptured section 1250 gain.
No client or prospective client should assume this article serves as a receipt of, or a substitute for, personalized advice from Merriman, or from a tax professional. The client or prospective client is responsible for determining whether any strategy discussed is appropriate or suitable for them based on their financial or tax situation. The client or prospective client should consult with a financial or tax professional regarding their specific situation.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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