Capital gains taxes on the sale of a home can be significant. However, with some good planning and record keeping, homeowners may be able to reduce their capital gains.
The capital gains tax rate can be up to 20% on capital assets held for longer than one year. Selling the asset in one year or less has no tax advantage as the rate is your ordinary tax rate.
To see this in action, we’ll use an example of a married couple filing jointly, earning $90,000/yr. Their long-term gains rate is 15%. On a $50,000 gain, that’s $7,500 in gains. On the same $50,000, if they sell at a 22% ordinary tax rate, taxes owed would be $11,000 or $3,500 more. As you can imagine, these savings can become quite large as the capital gain increases.
In addition to long-term capital gains rates, homeowners can potentially reduce their capital gains taxes by improving their home, which we will cover in this article.
Note that we’ll focus on single residences rather than investment properties.
Calculating The Adjusted Cost basis
The cost basis of a new home is the purchase price. For taxes, one needs to go a little further and calculate the adjusted cost basis. Due to related closing costs, every new home purchase will have an adjusted cost basis.
Adding and subtracting expenses to the cost basis creates the adjusted basis. Money spent on closing costs and improvements is added to the cost basis. This has the effect of increasing the cost basis and thus decreasing the capital gains tax. Here’s an example using a $400,000 home sold at $500,000:
Gain using cost basis and no adjustments:
$500,000 - $400,000 = $100,000
Gain using the adjusted cost basis with $15,000 in adjustments:
$500,000 - $425,000 = $75,000
With the adjusted cost basis, the result is a $25,000 reduction in capital gains.
Here’s how to calculate the adjusted cost basis. Add as many property-related expenses as possible:
Price paid for the property
+ legal fees
+ title fees
+ recording fees
+ acquisition cost
+ renovations/improvements
+ survey fees
+ related transfer/stamp fees
+ restoration of the property after damage or loss
Some expenses can reduce your cost basis, which potentially means owing more taxes:
- mortgage insurance fees or discount points (these might be reflected elsewhere when filing your taxes)
- insurance payments received due to a casualty or theft loss
The final number is the adjusted cost basis.
Renovations or improvements can be made anytime, even right after purchasing the property. The IRS definition of improvements is expenses that add to the property's value, prolong its useful life, or adapt it to new uses. These are called capital improvements.
Some capital improvements include a new room, appliances, floor, garage, deck, windows, roof, insulation, AC, water heater, ductwork, security system, landscaping, driveway, or swimming pool. All may qualify as improvements as they are meant to increase the home's value.
Many other items can be added to the above list. Working with an accountant can help ensure that an item qualifies. General maintenance is not considered an improvement for tax purposes. However, certain maintenance may qualify as part of a qualified improvement project.
Improvements with a life expectancy of less than a year can't be deducted from your cost basis.
Additional Considerations For Capital Gains Taxes
Homeowners should also consider the ownership test. It states that you must have lived in the residence for 2 of the last 5 years.
Assuming the above isn't violated, once the home is sold, the homeowner may not owe capital gains taxes, depending on how much the gain is. Any gain over $250,000 (single filer) is subject to capital gains taxes. The limit goes up to $500,000 for married filers.
Selling a home is a complex process. Working with a tax accountant can help ensure the correct calculation of your adjusted cost basis and the confirmation of the home ownership test.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Examples shown are hypothetical and for illustrative purposes only.
I'm well-versed in capital gains taxes on property sales and the strategies to minimize them. Let's break down the concepts in the article:
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Capital Gains Tax Rates: The tax rate can go up to 20% for assets held over a year. Short-term gains (less than a year) are taxed at the ordinary income tax rate.
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Example of Tax Calculation: A married couple with an annual income of $90,000 faces a 15% long-term capital gains tax rate on a $50,000 gain. Contrastingly, if their ordinary tax rate is 22%, they'd owe $11,000, $3,500 more than the capital gains tax.
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Reducing Capital Gains Taxes:
- Adjusted Cost Basis: Calculated by adding expenses like purchase price, closing costs, improvements, etc. It's essential for lowering capital gains.
- Adding to Adjusted Basis: Expenses like closing costs, improvements, renovations, legal fees, and acquisition costs increase the adjusted basis, reducing the capital gains.
- Improvements: IRS defines these as enhancements that raise property value, extend its life, or adapt it to new uses. Examples include new rooms, appliances, landscaping, etc.
- Qualified Improvement Projects: While general maintenance doesn't count, some maintenance work might qualify under a larger improvement project.
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Ownership Test: Homeowners must have lived in the residence for at least 2 of the last 5 years. Meeting this test can exempt them from paying capital gains taxes up to certain thresholds ($250,000 for single filers, $500,000 for married filers).
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Consulting Professionals: Given the complexity, working with a tax accountant helps ensure correct calculations and adherence to the ownership test.
This comprehensive understanding helps homeowners navigate the complexities of capital gains taxes on property sales, allowing for strategic planning and record-keeping to minimize tax liabilities.
