Despite the slumping real estate market, houses are still being sold and there is money to be made. Sellers need to take a close look at the exclusion rules and cost basis of their home to reduce taxable gain on their house.
First, the IRS home sale exclusion rule now allows an exclusion of a 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, unlike the previous one-time exemption, as long as you meet the following ownership and use tests.
During the 5-year period ending on the date of the sale, you must have:
- Owned the house for at least two years – Ownership Test
- Lived in the house as your main home for at least two years – Use Test
Tip: 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 main home. The IRS lists several factors relevant in determining which home is a principal residence, including 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 are a member of.
Tip: As the exclusion can be used over and over during your lifetime, you can re-establish your primary residence. File a Form 8822 to give the IRS official notice of a change of residence.
Note: Do not report the sale of your main home on your tax return unless you have a gain and at least part of it is taxable. Report any taxable gain on Schedule D (Form 1040). Further, loss on the sale of your main home can not be deducted.
Improvements Increase the Cost Basis
Additionally, when selling your home, consider all improvements made to the home over the years. Improvements will increase the cost basis of the home and thereby reduce the capital gain.
Additions and other improvements that have a useful life of more than one year can be added to the cost basis of your home.
Examples of Improvements
Adding an addition, finishing a basement, a new fence, new wiring or plumbing, paving driveway, landscaping, central air, flooring, insulation, swimming pool, security systems, etc.
Example: The Kellys purchased their primary residence in 1999 for $200,000. They paved the unpaved driveway, and added a swimming pool, among other things, for $75,000. The adjusted cost basis of the house is $275,000. The house then sold in 2008 for $550,000. It cost the Kellys $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. The amount realized $510,000 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 the Kelly’s 2008 personal tax return.
Tip: Home Energy Credit. Homeowners will benefit from extended energy saving credits when making their homes more energy-efficient in 2009 and 2010. Projects include energy efficient windows, doors, heating and air conditioning systems. The existing 10 percent tax credit for energy saving home improvements has been increased to 30 percent of a cost up to $1,500 and extends through 2010.
Partial Use of the Exclusion Rules
If you do not meet the ownership and use tests, you may be allowed to exclude a reduced maximum amount 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, natural or man-made disasters resulting in a casualty to your home, or an involuntary conversion of your home.
Example: If you get divorced after living in your home for approximately 1 1/2 years or 438 days and have a gain of $120,000 on the sale of your home, you can take 60% of the capital gain exclusion, as you lived in the house for 60% of the 2 year exclusion period (438 days divided by 730 days or 60%). Therefore, you would be allowed to deduct $150,000 of the capital gain (60% of $250,000 exclusion). No gain would be reported on this sale.
Good recordkeeping is essential for determining the adjusted cost basis of your home. Ordinarily, you must keep records for 3 years after the due date for filing your return for the tax year. However, keep records 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 basis
- Any worksheets or forms you filed to postpone the gain from the sale of a previous home before May 7, 1997.