We currently have at least two clients in this (un?)enviable position.
Both sellers owned their homes for a fairly long period, and made money on the sales. That’s great news for them, but it may turn out to be costly next April when they file their taxes.
Let’s review the rules quickly, to see what they might owe:
First of all, forget the old rules about avoiding tax if you buy a new home that’s more expensive. Or the rules about sellers age 55+ who could exclude $125,000 of profits. Those rules went out the window years ago, although for some reason they seem to stick in clients’ minds.
The new rules are actually simpler. Basically, you can ignore the first $250,000 of profits on the sale of your home if you’re single, and the first $500,000 if you are married.
But if you make over $250,000 (single) or $500,000 (married) in profits, you’ll owe capital gains tax on the excess.
This ability to eliminate up to 500k of gains is a huge tax boon Congress has provided to homeowners.
Of course, to take advantage of these provisions, there is the usual IRS fine print about how long you have to live in the home, what happens after a divorce, what happens if you’re posted overseas in the military, and so forth. To ensure you cross your “t’s” and dot your “i’s,” make sure to read the full IRS guidelines.
But here’s the really important part. Even if you think you made over 250k or 500k in profit, don’t despair about paying tax. You may not need to. Here’s why:
There are adjustments that increase your cost basis (what the IRS says you paid for the house) or decrease your selling proceeds. Those adjustments potentially reduce your profits and may eliminate any taxes.
What kind of adjustments are we talking about?
- Construction costs including architect and legal fees, building permits and materials and labor.
- Improvements you may have made to the house, such as adding a pool, an addition, a new roof or windows.
- Purchase costs like settlement fees or closing costs.
- Repairs made to prepare the house for sale—like painting, wallpapering, planting flowers, maintenance and the like—provided you complete them within 90 days of the sale and provided they were completed to make the home more saleable.
- Selling expenses including commissions, advertising and legal fees, and seller-paid loan charges.
- A step-up in basis at the death of an owner (for example, increase in cost basis when the husband dies, leaving the widow as the sole owner of the property).
Once you add in these adjustments, you might just find your big gain turns out to be not so big (and much less taxable!).
Financial Planning Tips:
Take 5 minutes right now to identify a safe place to keep important home records affecting your cost basis (like receipts documenting work done), or track the data on a computer program like Quicken.
If you’ve been in the home for many years, it’s hard to go back “after the fact” to reconstruct these important calculations from memory, so make sure to save them as you go.
Ask your tax preparer or financial advisor for guidance if you need help calculating your cost basis after a sale.
What could they owe