These days, many homeowners are considering selling their homes to take advantage of the booming housing market. In deciding whether to put their house on the market, homeowners should understand the tax consequences of a sale. To do this, they need to determine whether they qualify for an exclusion from taxes for the sale, make the appropriate adjustments to their basis in the property, and calculate the amount of “gain” from a possible sale.
Determining whether an exclusion applies
While the sale of real property is a taxable event under the Internal Revenue Code, taxpayers may be able to exclude up to $500,000 of the gain realized from the sale of their principal residence.
To qualify for a principal residence exclusion, a taxpayer must have owned and used the property as their principal residence for a period that totals two or more years during the five-year period ending on the date of the sale. The two years do not need to be continuous.
A taxpayer can use an exclusion no more than once every two years. The exclusion is generally limited to $250,000 for single individuals and married individuals filing separately. Married couples filing jointly can exclude up to $500,000 if at least one spouse meets the ownership requirement, both spouses meet the use requirement, and neither spouse has used an exclusion within the past two years. If one of the spouses does not qualify, the other spouse generally remains eligible for an exclusion of up to $250,000.
Taxpayers may exclude a fraction of the amount if they fail to meet the ownership and use requirements due to a change in place of employment, health, or other unforeseen circumstances. Special rules apply in determining ownership and use for taxpayers who receive out-of-residence care, inherit property from a spouse, transfer property pursuant to a divorce, or dispose of property where the rollover rules applied. The exclusion rule also generally applies to the sale of a remainder interest in a principal residence, allowing taxpayers to retain a life estate in a home while selling the remainder interest.
Adjusting basis in the property
The next step in analyzing the tax consequences of a sale of a home is to adjust the taxpayer’s basis in the residence. Basis is the property’s original cost plus any improvements the taxpayer made to the property. Taxpayers should include in basis many, but not all, costs associated with the purchase and maintenance of their home. This can include fees and closing costs, construction costs, and expenditures for various improvements.
Fees and closing costs
Some settlement fees and closing costs that can be included in basis are:
- selling commissions
- abstract of title fees
- charges for installing utility services
- legal fees
- recording fees
- survey fees
- transfer or stamp taxes
- owner's title insurance
Taxpayers cannot include fire insurance premiums, rent or charges for utilities or other services for occupancy of the house before closing, any fee or cost deducted as a moving expense (allowed for certain fees and costs before 1994), and charges connected with a mortgage loan.
Construction costs are also included in basis, but the inclusion differs depending on whether the taxpayer(s) contracted to have the home built or built the home themselves. For taxpayers who contracted to have the home built on land they own, basis is the cost of the land plus the cost to complete the house. This includes the cost of labor and materials, any amounts paid to a contractor, any architect's fees, building permit charges, utility meter and connection charges, and legal fees directly connected with building the house. Construction costs also include the down payment, any debt or notes the taxpayer gave to the seller or builder, and certain settlement or closing costs. In addition, the taxpayer must generally reduce their basis by the points the seller paid to the taxpayer.
If the taxpayer(s) built all or part of the home themselves, the basis is the total cost to complete the construction. The taxpayer(s) can include in basis any amount the seller owes that the taxpayer agrees to pay as long as the seller does not reimburse the buyer. This can include such costs as real estate taxes owed up through the day before the sale date, back interest owed by the seller, the seller's title recording or mortgage fees, charges for improvements or repairs that are the seller's responsibility, and sales commissions. However, taxpayers cannot include the value of their own labor, the value of any other labor for which they did not pay, or costs owed by the seller that the taxpayer paid.
Taxpayers can also add the cost of additions and improvements to their basis in the property. Some examples of improvements that increase basis are additions, lawns and grounds work, systems, interiors and exteriors, plumbing, and repairs done as part of a larger remodeling or restoration project.
Taxpayers must be careful not to include any costs of repairs or maintenance that are necessary to keep the home in good condition but do not add to its value or prolong its life. This would include such repairs as painting, fixing leaks, filling holes or cracks, or replacing broken hardware. Taxpayers must also exclude any costs of any improvements that are no longer part of the home and any improvements with a life expectancy of less than a year at the time of installation.
Calculating gain from the property
After determining whether they qualify for an exclusion and adjusting their basis in the property, taxpayers can then calculate the amount of “gain” in the property. The exclusion rule requires taxpayers to recognize gain for the rental or business use of a home to the extent of any depreciation taken after May 6, 1997. In such cases, the gain will be subject to a special capital gain rate of no greater than 25 percent. Additionally, an increase in basis offsets possible taxable gain upon the disposition of the residence.
Any decision about whether to sell a house requires a thorough examination of both the housing market as well as the personal tax consequences for the seller. As part of this examination, taxpayers should understand not only the rules around exclusions, gain, and basis, but must also determine whether they have adequate records to document these adjustments.
For more information about qualifying for this deduction, contact us. We are here to help.
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