Minimizing capital gains tax on a home sale

If you are considering selling your home, take a look at the exclusion rules and cost basis of your home to possibly minimize your taxes.

An IRS home sale rule allows the exclusion of gain up to $250,000 for a single taxpayer or $500,000 for a married couple filing jointly. This exclusion can be used over and over during your lifetime (but not more frequently than every 24 months), as long as you meet certain ownership and use tests.

During the five-year period ending on the date of the sale, you must have owned the house for at least two years and lived in the house as your main home for at least two years. And during the two-year period ending on the date of the sale, it is important that you did not exclude gain from the sale of another home.

The ownership and use periods need not be concurrent. Two years may consist of a full 24 months or 730 days within a five-year period. Short absences, such as for a summer vacation, count in the period of use. Longer breaks, such as a one-year sabbatical, do not.

If you own more than one home, you can exclude the gain only on your primary home. The IRS uses several factors to determine which home is a principal residence: the place of employment, location of family members’ main home, mailing address on bills, correspondence, tax returns, driver’s license, car registration, voter registration, location of banks you use, and location of recreational clubs and religious organizations you belong to.

As mentioned earlier, the exclusion can be used repeatedly every time you reestablish your primary residence. When you change homes, please call the office with your new address to ensure the IRS has your current address on file.

Only taxable gain on the sale of your home needs to be reported on your taxes. Further, you cannot deduct the loss on the sale of your main home.

Improvements Increase the Cost Basis

Also, consider all improvements made to the home over the years when selling your home. Improvements will increase the cost basis of the home, thereby reducing the capital gain.

Additions and other improvements that have a useful life of more than one year can also be added to the cost basis of your home.

Examples of improvements include: building an addition; finishing a basement; putting in a new fence or swimming pool; paving the driveway; landscaping; or installing new wiring, new plumbing, central air, flooring, insulation, or security system.

For example, consider a couple who purchased their primary residence in 2012 for $200,000. They paved the unpaved driveway, added a swimming pool, and made several other home improvements adding up to a total of $75,000. The adjusted cost basis of the house is now $275,000. The house is then sold in 2023 for $550,000. It costs them $40,000 in commissions, advertising, and legal fees to sell the house.

These selling expenses are subtracted from the sales price to determine the amount realized. The amount realized in this example is $510,000. That amount is then reduced by the adjusted basis (cost plus improvements) to determine the gain. The gain, in this case, is $235,000. After considering the exclusion, there is no taxable gain on the sale of this primary residence and, therefore, no reporting of the sale on their 2023 personal tax return.

Even if you do not meet the ownership and use tests, you may be allowed to exclude a portion of the gain realized on the sale of your home if you sold your home because of health reasons, a change in place of employment, or certain unforeseen circumstances. Unforeseen circumstances include, for example, divorce or legal separation or natural or man-made disasters resulting in damage to your home.

Recordkeeping

Good recordkeeping is essential for determining the adjusted cost basis of your home. Ordinarily, you must keep records for three years after the filing due date. However, you should keep documents proving your home’s cost basis for as long as you own your house.

The records you should keep include proof of the home’s purchase price and purchase expenses, receipts and other records for all improvements, additions and other items that affect the home’s adjusted cost basis, and any worksheets or forms you filed to postpone the gain from the sale of a previous home before May 7, 1997.

This column is for information only and should not be considered advice by anyone. Taxes are complex and mistakes can be costly. If you have questions, consider seeing the help of an experienced tax professional.

Norman G. Grill is managing partner of Grill & Partners LLC, certified public accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien.