One of the benefits to home ownership is being able to sell your home without paying any capital gains tax. To be eligible for this tax exemption, you must have owned and lived in your home as your primary residence for a total of at least two of the last five years.
Single people (or married individuals who file taxes separately) can exclude up to $250,000 of their gain, and married couples who file jointly can exclude up to $500,000 of their gain. Uncle Sam lets you claim this exclusion once every two years.
There are many ways to define the value of your property. There’s the acquisition price (the amount you paid for it), the assessed value (the amount the county uses to calculate property taxes), the basis (the acquisition price plus improvements minus deductions), and the sale price (the amount a new buyer pays you to purchase the property). Although the acquisition price doesn’t change, the assessed value and basis do.
Capital gains are calculated by subtracting the basis from the net sales price. This makes it important to understand how the basis is calculated — and how it changes. The higher the basis, the smaller your reportable (and therefore taxable) gains. The basis of a property typically increases when the homeowner significantly improves the property, including remodels and additions. Here’s the catch: the homeowner must be able to document the investment in those improvements. So, if you added a pool but paid the contractor under the table, your basis won’t increase.
This capital gains tax exemption is only for homes used as the owner’s primary residence. As such, most of these properties don’t have deductions in the form of depreciation. However, if a home includes a home office or if the homeowner rented out part or all of the home and depreciated it during that time, then the basis would drop. A lot line adjustment could also reduce your basis (for example, if your neighbor paid you for a portion of the property that used to belong to you).
Because the capital gains tax exemption is so valuable, it’s worth considering the timing on the sale of your current home. Sometimes people who can afford to buy a new home without selling their old one ask whether they should rent their current home until the housing market improves. This is a fine strategy up to a point.
The key questions are how long the housing market will take to pick up and what that recovery will look like. Remember, to be eligible for the tax exemption, you must have lived in the property as your primary residence for two of the last five years. If you decide to rent your old house while the market improves, be sure you don’t wait so long that you no longer meet the exemption requirement.
Paying taxes on the entire gain from the home sale adds up; the tax liability could be as high as 35 percent of $500,000 (the exemption for a married couple), which is $175,000. If you held onto your house in hopes of a higher sale price at some future date, would you have earned $175,000 in rent and/or would the increase in the value of the property cover that much? Better to get a slightly lower sales price and take advantage of the tax exemption than to wait for a slightly higher sales price but be required to pay capital gains tax on the $500,000 you could have exempted.
Note: If you inherit property from your parents, you benefit from a “stepped-up” basis. That is, the basis becomes the fair market value as of date of death of parent.
Remember, even if you pay no capital gains tax, you should still file a 1099-S Form (Proceeds from Real Estate Transactions). Your CPA can provide details. Trust me when I say you do not want to get into an argument with the IRS. I once paid $9,000 in attorney’s fees during a protracted disagreement with the IRS, only for them to finally admit I was right about only owing $48 in taxes.
In this and all matters related to taxes, you must consult with your CPA. I am not an accountant, and this column is never intended as advice but rather food for thought. Each person’s financial situation is different, and small differences can have huge tax implications.
If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 45 years. The opinions expressed here are his and do not necessarily represent his affiliated organizations.
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