Lock in Home Sale Gain Exclusion

The home sale gain exclusion might be the “biggest and best” federal income tax break on the books. If you qualify, you can pocket up either a quarter or a half million dollars of profit tax free from the sale of your home – no strings attached.

Potential problem: The seemingly generous home sale exclusion might not be enough to shelter your gain if your home has appreciated significantly since you bought it. You may have to pay a king-sized tax bill after selling your castle for a whopping big profit.

Keep detailed records of home improvements. These expenditures increase your tax basis for home sale gain calculation purposes. So, when you finally do sell your home, the higher basis reduces the taxable amount of the gain. Without detailed records, you’re just taking a shot in the dark at your actual basis. Document qualified expenditures each year.

If you’ve owned and used your home as your principal residence for at least two of the previous five years, you can elect to exclude from federal income tax up to $250,000 of home sale profit if you’re single filer; $500,000 for joint filers. There are no limits on the number of times you can claim the exclusion. The gain for purposes of the exclusion is the difference between the net selling price and your adjusted basis in the home. For example, your basis may have been reduced to reflect rollovers from prior home sales. On the other hand, certain home improvements can increase your basis to cut down your taxable gain or to ensure that your gain is fully sheltered by your allowable exclusion.

Example: You and your spouse bought your first home for $100,000 and sold it for $400,000. Then you bought your current home for $450,000. Under the rules in effect at that time, you avoided any current tax by rolling over the home sale proceeds into your current home. During the past few years, you’ve made significant improvements, including an in-ground pool, deck and finished basement. The total cost of the improvements was $125,000. Now you’re looking to sell the home for $750,000.

At first glance, you might think you would owe no tax on the home sale. Reason: Your $300,000 profit ($750,000 less $450,000) is covered by the $500,000 home sale exclusion for joint filers. But your actual basis after the sale of your first home is $150,000 (purchase price of $450,000 less deferred gain $300,000). Even after you claim the home sale exclusion, you’d have a taxable gain of $100,000 ($750,000 minus $150,000 basis minus $500,000 home sale exclusion).

This is where detailed tax records can come to the rescue. If you can document the $125,000 of home improvements, you can increase your basis to $275,000 ($150,000 plus $125,000). So your taxable gain comes to $475,000 ($750,000 less $275,000) which is less than the $500,000 threshold. Thus, your entire gain is tax free!

Besides tracking current expenses, comb over past credit card statements and checkbooks for proof of home improvements. You may be surprised at some of the costs that can help boost your basis.

Tip: Maintain a logbook, ledger or other record of expenses you’re adding to your basis. Keep the information stored in a safe place. Make backup copies of electronic files.

Tax Checklist of Home Improvements

Such improvements which increase your home’s value or prolong its useful life, can be added to the home tax basis.

  • Finishing a basement or attic
  • New plumbing, heating or air conditioning system
  • Adding a fireplace or new room
  • Outside improvements such as a patio, deck or swimming pool
  • Installing aluminum or vinyl siding or storm windows and doors
  • New landscaping

Note that the cost of repairs – such as expenses for painting, fixing gutters, re-plastering walls and replacing broken windows – are not added to your basis. However, if you lump in repairs with home improvements you can argue that the entire cost is for a general renovation that increases your tax basis.

Tip: Schedule repairs when you’re doing improvements. This gives your basis an extra nudge.

Add these expenses to your basis to reduce your potential taxable gain:

  • Attorney fees
  • Closing costs and settlement fees
  • Title search and insurance
  • Broker commissions
  • Survey and appraisal fees
  • Recording fees for deed and mortgage

Tip: These expenses will be reflected in your HUD closing statement.

Small Business Tax Strategies
July 2021