Rising home prices raise a tax problem that many people have not worried about for years. To avoid paying high taxes on gains from home sales, home sellers need to keep track of the tax basis of their residences.
Long-time homeowners, especially on the coasts and resort areas, have substantial home equity. The tax law enacted in 1997 provides that single individuals can exclude the first $250,000 of gain from the sale of a principal residence, and married couples can exclude up to $500,000 of gain. A home must have been owned and been the principal residence of the seller for at least two of the five years preceding the sale. The exclusion can be used no more often than every two years. A sale that occurs less than two years after the previous sale gets a pro rated gain, unless the seller qualifies for one of the exceptions to the two-year rule.
The tax exemption limits seemed generous in 1997, but they shelter only a portion of the gain for many home sellers in the hot markets. More and more home sellers are reporting taxable gains. One way to reduce taxable gains is to maximize the basis of the residence.
Taxable gains are determined by starting with the sale price of the home. Home selling expenses are subtracted from the sale price, then the tax basis is subtracted to determine the gain.
The tax basis is the most significant deduction from the sale price. Unfortunately, many people understate the basis and pay more taxes than they should.
The cost of the home usually is the starting point for tax basis. But amounts might be added to or subtracted from the cost.
If one or more prior homes were sold for a profit under old law, then gains from those homes were rolled over into the current home and taxes were deferred. Those deferred gains are subtracted from the cost of the latest home when computing the basis.
A number of expenses associated with the purchase of the home are added to the cost to determine the basis. These expenses include abstract fees, charges for installing utility lines, legal fees (including title search and preparing the sales contract and deed), recording fees, survey fees, transfer taxes, and title insurance. Any expenses of the seller that the buyer agrees to pay also increase the basis. These expenses can include real estate taxes, back interest, recording or mortgages fees, improvements or repairs, and sales commissions.
Some personal living expenses associated with the purchase of a home increase the basis. These include insurance premiums, rent for occupying the home before closing, deductible moving expenses, and charges for obtaining a mortgage.
The basis computation does not end when the purchase is complete. Some expenditures during ownership can increase the basis.
Improvements to the home increase the basis. An improvement increases the value of the home or increases its expected life. An addition to the home or installation of a pool is an improvement. Adding or enlarging a deck is an improvement. But repairs that maintain the good condition of a home are not added to the basis. These are personal expenditures. Such expenditures include painting, chimney cleaning, and new roofing.
Some expenditures are subtracted from the basis.
Subtractions from the basis include deductible casualty losses (or insurance payments received for casualty losses), selling an easement or right of way, and using first time homebuyer tax credits.
Business or rental use of a home also can cause a reduction in basis equal to the depreciation that is allowed or allowable.
The basis rules are a good reason not to give your home to loved ones as part of an estate plan. If you give the home, the children generally take the same tax basis you had. All the gains accrued during your lifetime will be taxed when your loved ones sell the home. But when a home is inherited, under current law the beneficiaries get to increase the basis to the current fair market value. No gains are owed on the appreciation during your lifetime. It is better to sell the home to your children or let them inherit it than to give it to them.
The home sale exemption applies only to a principal residence. If you have a second home or vacation home, it is treated as an investment property when it is sold. Any gain is taxed, and the gains would be long-term gains if the house was held for more than one year. If possible, establish a house as your principal residence before selling. The home must be the principal residence for at least two of the five years that immediately precede the sale in order to qualify for the exemption. The two years do not have to be consecutive and do not have to be the two years just before the sale.
One of the more difficult tasks people have when computing the gain from a home sale is proving the basis. You need records to establish the initial cost and any adjustments to the basis such as improvements. For many homeowners, that means keeping records that are decades old. If a prior home was sold under the old rules and the gain was deferred by rolling it over into the new home, then the tax return for the year of the rollover should be kept.
Additional information about computing the basis of a residence is contained in IRS Publication 523. It is available free on the IRS web site or by calling the IRS.