While it may be tempting to sell your home upon finding out that its value has skyrocketed, we advise you to proceed with caution. Many individuals in this situation do not realize that the profits from their home sales are liable to be taxed. Unfortunately, by the time they find this out, they may have already spent the money. Understanding how capital gain taxes work can help you avoid such scenarios.
Changes in Tax Rules for Capital Gain Taxes
Prior to 1997, home sellers were not required to pay taxes on the profits gained when they purchased homes of equal or larger value within two years of selling their homes. Additionally, until 1997, individuals above the age of 55 were also able to use one-time exclusions that allowed them to avoid paying taxes on home sale profits of up to $125, 000.
All of this changed with the introduction of the Taxpayer Relief Act in 1997. The rules were changed so that instead of moving their profits into another property, homeowners could exclude up to a quarter of a million dollars in home sale profits from their income. To be able to meet the requirements for a complete exclusion, home sellers had to be in ownership of and live in their property for at least two of the five years preceding the sale. While these exclusion limits have not changed in the quarter-decade since, home values have tripled. While having taxable gains on home sales was once rare outside of high-cost cities and high-end properties, financial experts often say that this is no longer the case.
Understanding Your Tax Basis with Capital Gains
When it comes to determining your gains, the first step is identifying the amount that you realized from a sale. This refers to the sales price minus selling costs like real estate commissions. From here, you can figure out your tax basis; generally, this refers to the price you paid for the home, including improvements and closing costs.
If you previously deferred gains on a home sale, your tax basis could be lower than the purchase price. There are also other factors that may increase your tax basis and lower potentially taxable gains, which include owning a home with a spouse that passed away or living in a community property. The rules and regulations differ from state to state, so if you have any concerns or questions, we recommend consulting an experienced attorney.
Reducing Your Gains
Home improvements are one way to increase your basis. To qualify for this, improvements should add to your home’s value, prolong its life and adapt to new uses. These may include things like adding rooms, updating kitchens, and plumbing, and performing major remodels. Repairs and maintenance, however, usually do not qualify as veritable home improvements. Additionally, removed or replacements do not count. To further your understanding of how to reduce capital gains, we recommend reviewing Publication 523 of the IRS. If you are looking for ways to safeguard your property, we recommend reading up on how to protect your personal residence.
