With the real estate market looking up in many areas, money is out there to be made. Sellers, it's time to take a close look at the exclusion rules and cost basis of your home to reduce your taxable gain.
The IRS home sale exclusion rule now allows an exclusion of a gain up to $250,000 for a single taxpayer or $500,000 for a married couple filing jointly. This exclusion can be used over and over during your lifetime, unlike the previous one-time exemption, as long as you meet the following Ownership and Use tests.
During the 5-year period ending on the date of the sale, you must have:
- Owned the house for at least two years - Ownership Test
- Lived in the house as your main home for at least two years - Use Test
Tip: The Ownership and Use periods need not be concurrent. Two years may consist of a full 24 months or 730 days within a 5-year period. Short absences, such as for a summer vacation, count in the period of use. Longer breaks, such as a 1-year sabbatical, do not.
If you own more than one home, you can exclude the gain only on your main home. The IRS uses several factors to determine which home is a principal residence: place of employment, location of family members' main home, mailing address on bills, correspondence, tax returns, driver's license, car registration, voter registration, location of banks you use, and location of recreational clubs and religious organizations you belong to.
Tip: As we said, the exclusion can be used repeatedly, every time you reestablish your primary residence. When you do change homes, let us know your new address so we can ensure the IRS has your current address on file.
Note: Only taxable gain on the sale of your home needs to be reported on your taxes. Further, loss on the sale of your main home cannot be deducted. Ask us for details.
Improvements Increase the Cost Basis
Additionally, when selling your home, consider all improvements made to the home over the years. Improvements will increase the cost basis of the home and thereby reduce the capital gain.
Additions and other improvements that have a useful life of more than one year can be added to the cost basis of your home.
Examples of Improvements
Examples of improvements include: building an addition; finishing a basement; putting in a new fence or swimming pool; paving the driveway; landscaping; or installing new wiring, new plumbing, central air, flooring, insulation, or security system.
Example: The Kellys purchased their primary residence in 1999 for $200,000. They paved the unpaved driveway and added a swimming pool, among other things, for $75,000. The adjusted cost basis of the house is $275,000. The house is then sold in 2011 for $550,000. It costs the Kellys $40,000 in commissions, advertising, and legal fees to sell the house.
These selling expenses are subtracted from the sales price to determine the amount realized. The amount realized in this example is $510,000. That amount is then reduced by the adjusted basis (cost plus improvements) to determine the gain. The gain in this case is $235,000. After considering the exclusion, there is no taxable gain on the sale of this primary residence and, therefore, no reporting of the sale on the Kelly's 2011 personal tax return.
Tip: Home Energy Credit. Home energy-efficiency tax credits were extended into 2011 at reduced limits and with modifications. A tax credit of 10% of cost up to $500 is available for projects including energy-efficient heating and air-conditioning systems, roofing, and insulation. Further limitations do exist for certain items. For example, for the replacement of windows and skylights, the credit is 10% of cost, capped at $200. But you can still take advantage of tax credits at 30% of cost for alternative energy projects, including geothermal and solar projects and wind turbines. Please contact us for further information on these credits.
Partial Use of the Exclusion Rules
If you do not meet the Ownership and Use tests, you may be allowed to exclude a portion of the gain realized on the sale of your home if you sold your home because of health reasons, a change in place of employment, or certain unforeseen circumstances. Unforeseen circumstances include, for example, divorce or legal separation, natural or man-made disasters resulting in a casualty to your home, or an involuntary conversion of your home.
Example: If you get divorced after living in your home for approximately 1 1/2 years or 438 days and have a gain of $120,000 on the sale of your home, you can take 60% of the capital gain exclusion, as you lived in the house for 60% of the 2-year exclusion period (438 days divided by 730 days, or 60%). Therefore, you would be allowed to deduct $150,000 of the capital gain (60% of the $250,000 exclusion). You would NOT need to report any gain on this sale.
Good recordkeeping is essential for determining the adjusted cost basis of your home. Ordinarily, you must keep records for 3 years after the filing due date. However, keep records proving your home's cost basis for as long as you own your house.
The records you should keep include:
- Proof of the home's purchase price and purchase expenses
- Receipts and other records for all improvements, additions, and other items that affect the home's adjusted cost basis
- Any worksheets or forms you filed to postpone the gain from the sale of a previous home before May 7, 1997
Tax considerations can be confusing. If you have any questions on taxes related to the sale of your home, give us a call.