One of the most popular provisions in the tax code is the $250,000 capital gain exclusion ($500,000 for a married couple) of any profit made when selling your home. Thanks to the rule, most primary-residence home sales transactions are not a taxable event.
- But what if the tax law is changed?
- What if you rent out your home?
- What if you cannot prove the cost of your home?
Here is the problem with this popular provision
The gain exclusion is so high that many homeowners do not keep track of the true cost of their home. They assume that they will not enjoy such significant appreciation in the value of their home, so they have no need to maintain improvement records, but that is simply not the case. Recently, our clients have been selling their homes for amounts far greater than they ever anticipated. In many cases, the appreciation in the property is well above the capital gain exclusion amount. The result? A potentially unexpected tax bill.
To calculate your home sale gain, take the sales price received for your home and subtract your basis. Basis is an IRS tax term that equals the original cost of your home including closing costs, plus the cost of any improvements you have made in your home.
An example: you bought your home for $500,000. The seller paid all closing costs. While you owned the home, you made $100,000 worth of improvements. You sell your home for $1,000,000. Closing costs are $50,000, which adds to your basis. Your total cost of ownership is $500,000 plus $100,000 plus $50,000 for a total of $650,000. The net appreciation in your home is $350,000 ($1M minus $650,000).
To keep the tax surprise away, always keep documents that support calculating the true cost of your home. These documents should include:
- Closing documents from the original home purchase
- All legal documents
- Canceled checks and invoices from any home improvements
- Closing documents supporting the value when the home is sold
- Tax returns
There are some cases when you should pay special attention to tracking your home’s value:
- You have a home office. When a home office is involved, it can impact the calculation of the capital gain exclusion. This is especially true if you depreciated part of your home for business use.
- You live in your home for a long time. Most homes will rise in value. The longer you stay in your home, the more likely the value of your home will rise over time. For example, a sizable gain can occur when an elderly single parent sells their home after living in it for over 50 years.
- You live in a major metropolitan area. Certain areas of the country are known to have rapidly increasing property values.
- You rent your home. Any time part of your home is depreciated, it can impact the calculation for available gain exclusion. Home rental also can impact the residency requirement calculation to receive the home gain tax exclusion. In general, as long as the home utilized as your primary residence in at least two of the last five years, you can qualify for the capital gain exclusion.
- You recently sold another home. The home sale gain exclusion can only be used once every two years. If you recently sold a home at a gain, keeping all documents related to your new home will be critical.
The best way to protect this tax code benefit is to keep all home-related documents that support calculating the cost of your property. Remember, when things get complicated, it is time to call a professional tax advisor. If we can help, please let us know.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.