With home prices rising 20% nationwide in the past year and in some markets, even dramatically more, many homeowners are excited about the equity in their homes. In the past, most homeowners were not concerned about profit from the sale being taxed but some may be surprised.
The profit homeowners make on the sale of their homes have enjoyed a generous exclusion. Since 1997, for qualified sales, single taxpayers exclude up to $250,000 of capital gain and married taxpayers filing jointly, can exclude up to $500,000 of gain.
Prior to the Taxpayer Relief Act of 1997, homeowners over the age of 55 were only allowed a once in a lifetime exclusion of $125,000. The new rule greatly increased the amount of excluded profit to the extent that most homeowners did not think about paying tax on the profit from their principal residences.
Section 121, commonly called the Home Sale Tax Exclusion, requires that you owned and used the property as your principal residence for two out of the previous five years. This allows for a temporary rental of the property and still be able to qualify for the exemption. It can be claimed only once every two years.
Cost basis is determined by Purchase Price plus certain closing costs at acquisition plus capital improvements made to the home during ownership. Sales price, less selling expenses, is considered net sales price from which the cost basis is subtracted to arrive at capital gains on the sale.
Capital improvements made to a home increase the cost basis and effectively, lower the gain in the sale. It is important for homeowners to keep records of the money they spend during the time they own the home.
Some improvements are apparent like a swimming pool, new fence, or roof but some are not so obvious. Replacing a faucet or a light fixture can be a capital improvement and even though the cost is small, lots of these items over the lifetime of owning the home add up.
The three rules for identifying capital improvements listed in IRS publication 523 are: 1) does it materially add value to the property? 2) does it extend the useful life of the property? 3) does it adapt a portion of the home to a new use?
While taxpayers are allowed to reconstruct a register of the improvements made during the time they owned their home, some things will undoubtedly, be overlooked. It is much better to have a written record of all money spent on the home in a contemporaneous manner and keep receipts for items over $75.
It is better to have the record of all items available when you are ready to make the capital gain determination. You'll save time and probably pay less taxes having the list readily available whether you do your taxes or have a professional do them.
For more information, download the Homeowners Tax Guide.