Congress clearly intended that most homes in this country would sell without federal income tax consequences.
It passed legislation that allows you to exclude up to $250,000 in gain when you sell your personal residence, and $500,000 in gain if you’re married, as long as you meet a few basic requirements.
What Congress did not do was to index the amount of gain that you can exclude.
Dramatic increases in the market values of their homes have resulted in taxable gains upon sale for many homeowners. As a result, it has become increasingly important to be able to accurately establish your basis in your home for tax purposes.
You have a gain if the selling price of your home (i.e., the total amount you received, including money, any notes or mortgages the buyer assumed, and the value of any other property you received) is greater than the sum of the following:
your selling expenses—including commissions, advertising fees, legal fees and any buyer’s expenses you pay
the adjusted basis of your home—in general, the cost of your home including improvements
If the amount of your gain exceeds $250,000 ($500,000 if you’re married), the excess is taxable.
As a result, tracking and maximizing the adjusted basis of your home is critical. Your basis is a fundamental element of the gain calculation for tax purposes.
Calculating Your Home’s Adjusted Basis
Under normal circumstances, your adjusted basis is calculated as the original cost of your home plus certain settlement fees and closing costs, and the value of any significant home improvements you made while you owned it.
The basis is reduced by the amount of depreciation taken for business or rental use, as well as deductible casualty losses and certain tax credits. As a result, your basis can change over time.
The closing and settlement costs that you can include are charges for installing utility services, legal fees, recording fees, survey fees, transfer taxes, owner’s title insurance, and any amounts the seller owes but you agree to pay, such as certain real estate taxes, back interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
You cannot include fire insurance premiums, rent for occupancy of the house before closing, charges for utilities or other services related to occupancy of the house before closing, any fee or cost that you deducted as a moving expense, charges connected with getting a mortgage loan (such as mortgage insurance premiums, loan assumption fees, the cost of a credit report, and the fee for an appraisal required by a lender), and fees for refinancing a mortgage.
Improvements include those expenditures that add value or extend the useful life of your home by at least one year. They do not include maintenance and other amounts that extend the useful life by less than one year.
There are, however, exceptions to the general rule for calculating basis.
If you previously deferred a gain under the old rollover rules, you need to reduce your basis by that deferred gain.
If you inherited your home or received it as a gift, your adjusted basis may reflect the home’s fair market value or the adjusted basis of the person who gave or bequeathed you the home.
If you received your home in a trade, your adjusted basis is based on the adjusted basis of the home you traded for it.
If you contracted to have your home built, your basis is the cost of the land, plus the cost of labor and materials, any amounts paid to a contractor, architect’s fees, building permit charges, utility meter and connection charges, and legal fees directly connected with building the home.
If you have taken depreciation on your home, a portion of your gain will be taxable even if your gain is less than the otherwise excludable amount.
Documenting Your Adjusted Basis
For federal tax purposes, you should retain all documents relating to the original purchase of your home and any significant improvements for a period of at least three years after you sell your home.
The recommendation reflects the fact that the IRS can audit your federal income tax return for three years after it is filed. (Each state may also have its own record retention requirements.)
It’s often wise to keep these documents longer, however, as there is no statute of limitations if the IRS alleges fraud or failure to file a return.
If you don’t have good, solid records to establish your home’s basis and you are challenged by the IRS, the courts do allow you to submit other corroborating evidence, such as photographs of major renovations.
However, in most cases, any benefit of doubt is resolved in favor of the government.
For additional general information, you can refer to IRS Publication 523, Selling Your Home. And you can always contact us to discuss your specific situation.
