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Profitability - Capital Gains Taxes

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Do You Understand Capital Gains?

If you own real estate, you've got a partner and his name is Uncle Sam. Any time you make a profit selling real estate he'll have his hand out for his share. Even with the generous tax relief given homeowners it is not hard to find yourself in a position where you'll owe a considerable amount in taxes when you sell your home. We recommend that calculating your Capital Gain should be left to the professional tax attorney or accountant, however, it's helpful to have a basic understanding of why you could owe a very large sum.

What Are Capital Gains?
The Calculation
Resources

Real Estate Capital Gains are treated differently than other investments.

We repeat: calculating Capital Gain should most often be left to the professional tax attorney or accountant. However, using the information we provide here you can estimate the taxes you may owe when you sell your primary residence or investment property.

When you sell a stock, you owe taxes on your gain. The "gain" is the difference between what you paid for the stock and what you received for the stock when you sold it. If you made money on the transaction, the IRS will want a share of it -- called a capital gains tax. The same is true with selling a home (or a second home or investment property), but the IRS gives your personal residence some special considerations.

The tax code is generous and excludes from taxes a large portion of home-sale profit. A single seller can walk away with up to $250,000 tax-free when he sells his primary residence; a married couple up to $500,000.

A Special Real Estate Exemption for Capital Gains

But, if you net more than that, you could be yet another victim of "capital gains shock." And don't think it's just rich folk who are mired in this capital gains trap. People who have owned their homes for a long time, especially those in some skyrocketing real estate regions, may see substantial appreciation on their property. Even though home values in some regions may have experienced recent and significant devaluation, appreciation over the long haul and during the real estate "bubble" may have quadrupled the original value of your home.

One of the questions that tax preparers and accountants hear all the time is: “I added a family room, and a patio, replaced the roof, and planted a shrub. Can I take it off my taxes?” The usual answer - “No. Not until you sell your house.” So, save your receipts and keep good records of any improvements you make to your home because the cost of these improvements will be added to the purchase price of your home to determine the cost basis of the house when you sell it. The basis is subtracted from the new sales price (with certain adjustments) to determine your gain or loss of capital on the house.

How to Calculate the Capital Gain on the Sale of Your Home

In real estate, capital gains are based not on what you paid for the home, but on its "adjusted cost basis." The "adjusted basis" is what you paid for the home plus your "out of pocket expenses" to date.

To calculate adjusted cost:

Take the purchase price of the home: This is the actual sales price that you paid for the home, even if it was 30 years or more ago. (It is not the amount of money you actually contributed at closing, nor does it include all the interest you've paid on the home since.)
Add adjustments:
1. Cost of purchase — "what you paid for the home" including transfer fees, attorney fees, inspections, but not points you paid on your mortgage.
2. Cost of improvements — including room additions, deck, etc. (Note - It is here, that we tax payers most often run afoul of the tax code! As much as we would like to call them improvements, they do not include repairing or replacing something already there, such as putting on a new roof or buying a new furnace.)
  1. Just because you spent $20,000 to "improve" the look of your kitchen, does not mean it was an "improvement" in the eyes of the IRS. However, if you "added" a fireplace to your kitchen in the process - that might be considered an improvement.
  2. If you operated a business from your home or rented a portion of your home to someone, part of your home improvements may already have been deducted as business expenses through depreciation. These will be subject to what is known as "recapture." The tax concept of depreciation and recapture is beyond the scope of this discussion. (Text books and college courses have been devoted to the subject.) So, if depreciation is involved, you'll probably need to consult your tax attorney or accountant before continuing, or remember to factor it in later.
  3. The IRS provides a nifty chart on page 8 of its Publication 523, Selling Your Home. Here you'll see projects the IRS considers as improvements.
  4. Please consult your tax attorney or accountant for guidance through this gooey, if not goofy, part of the tax code.
  5. Finally, our elected officials love to fiddle with capital gains legislation, although very few have any idea of the consequences (of this or any other tax matter). It's an easy source of revenue that they mistakenly think only applies to the very rich. So be sure to stay abreast of any changes in the law.
3. Cost of sale — attorney’s fee, real estate commission, survey, transfer taxes, etc. (STOP - do not include the property taxes that you had to pay up to the date of closing. Property taxes are a yearly deduction, and if you itemize your return you can take the deduction when you file; and if you don't itemize, the IRS contends that it's included it in your standard deduction. Therefore, they won't let you deduct property taxes twice - so do not include it into your "adjusted cost basis" calculation. Many have tried and all have failed.)
4. Cost of sale repairs — including inspections or money you spent to fix up your home just prior to sale. It can also include repairs you made to satisfy your buyer's home inspection concerns. ( Yes, this seems a contradiction of item ll above. However, you can deduct a repair if it were made as a requisite of a purchase contract. A repair that you could not have deducted had you made it last year on your own. Go figure!)
Total of all four items in #2 above. This becomes the "adjusted cost basis" of your home.
Subtract adjusted cost basis from the sale price of your home. This is your Capital Gain.

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