Liz Weston, CFP®
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Congratulations if your home has gone up in value. If you decide to sell, beware.
Financial advisor James Guarino says some clients don’t realize profits from home sales may be taxable until their returns are prepared — and by then, they may have spent the windfall or invested the money in another home.
says Guarino, who is a certified public accountant and certified financial planner in Woburn, Massachusetts.
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Older homeowners who took advantage of past tax rules, which allowed people to transfer earnings from one home to another, could face an especially nasty surprise. These legacy rules can result in you being taxed even if you are under the current exemption limits of $250,000 per person.
Understanding how to calculate home sale profits—and how you can legally reduce your tax bill—can save you money and put pressure on you if you plan to take advantage of the current home price boom.
How have tax rules changed?
Until 1997, home sellers did not have to pay taxes on their profits if they purchased another home of equal or greater value within two years. Additionally, people 55 and older can use the one-time exclusion to avoid paying taxes of up to $125,000 in home sale earnings.
The Taxpayer Relief Act of 1997 changed the rules so that instead of transferring profits to another home, homeowners could exclude up to $250,000 in home sale profits from their income. To qualify for full exclusion, home sellers must have owned and lived in the home for at least two of the five years prior to the sale. Married couples can house up to $500,000.
These exclusion limits have not changed in 25 years, while home values have nearly tripled. The median home sale price when the law was passed was $145,800, according to the Federal Reserve Bank of St. Louis. The median was $428,700 in the first three months of this year. Median means half of the homes sold at a lower price and the other half at a higher price.
Financial advisors say getting taxable gains on the sale of homes used to be relatively rare outside of high-end real estate and high-cost cities, but that’s no longer true.
Why does your tax base matter
Your first step in determining your earnings is to determine how much you made from the sale. This is the sale price minus any selling costs, such as real estate commissions. Then select your tax base. This is the price I paid for the house overall, plus some closing costs and improvements. The higher the basis, the lower the potential taxable profit.
Let’s say you make $600,000 selling your home. I originally bought it for $200,000 and remodeled the kitchen for $50,000. You can subtract $250,000 from $600,000 to get $350,000 in capital gains.
If you are single, you can take $250,000 from the profit and pay tax on the remaining $100,000. (Long-term capital gains are typically taxed at 15% at the federal level, although making a large enough profit may push you into the higher 20% capital gains bracket. Government tax rates vary.) If you are married and can Excluding gains of up to $500,000, you will not owe any tax.
Your tax basis may be less than the purchase price, however, if you previously deferred the gain on the sale of a home, says CPA Mary Kay Foss of Walnut Creek, California. Let’s say you sold a home before 1997 and made a profit of $175,000 on the new home—the one that cost you $200,000. The initial tax basis for your home will be only $25,000. Now, if you realize $600,000 from the sale, your capital gain would be $525,000, even with a $50,000 kitchen remodel.
Other factors may increase your tax base and reduce your potential taxable earnings. If you own a home with your spouse who has passed away, for example, at least half of the home’s foundation will be “raised” or increased to its market value at the time of your partner’s death. If you live in a community property state like California, both halves of the home get this step in the tax base.
How to reduce your winnings
Another way to strengthen your foundation: home improvements. To qualify, improvements must “add to the value of your home, extend its useful life, or adapt to new uses,” according to IRS Publication 523, Selling Your Home.
room additions, updated kitchens, and new plumbing counts; Repairs or maintenance, such as painting, usually do not. You also can’t count improvements that are removed or replaced later.
Home sellers should review Publication 523 carefully to understand the costs that could reduce their earnings, and keep documents — such as receipts — in case they’ve been audited, says Susan Allen, senior director of tax practices and ethics at the American Institute of Certified Public Accountants.
“Be proactive in maintaining your records because we all know that if you go back 10 years and look for something, it’s going to be very hard to find,” says Allen.
This article was written by NerdWallet and originally published by the Associated Press.