Every so often (okay, nearly daily), I pull up the Redfin app on my phone to gauge what’s happening with the real estate market in my part of the city. It’s mind blowing! There will be periods where there is virtually nothing for sale. There will be periods (like now) where inventory starts to pick up, but prices never start below $900k, even for “as-is” dumps that are soon to meet Mr. Wrecking Ball.
It’s no secret that housing in Seattle (and surrounding areas) is ridiculously expensive. You don’t need me to write a blog post to tell you that. Instead, I’m writing to talk about one ramification of these skyrocketing housing prices that may very well impact you – capital gains taxes. More importantly, we’ll look at how to avoid them!
No one likes paying capital gains taxes, despite the fact that it inherently means you made money. Fortunately, many house sellers never have to, thanks to a long-standing and very generous $500,000 exemption (married/filing jointly) ($250,000 if single) that applies on most home sales (more on that below). However, with prices reaching unprecedented levels, more sellers than ever are suddenly finding themselves saddled with a hefty tax bill, and it’s often one they could have avoided with better planning and recordkeeping. That’s what we really want to tackle today. We’ll spend 2-3 pages talking about something the IRS spends 22 pages on in this bulletin. Suffice it to say this is intended to be a primer, not definitive tax advice. Consult with us, the IRS materials, and/or your tax professional for further guidance specific to your situation.
Before we go much further, it’s helpful to understand more about this $500,000 exemption and the basics of capital gains taxes on real estate. If you have lived in your home as your primary residence for any 2 of the past 5 years, you most likely qualify to take this exemption. What this means is that if your realized capital gain is less than $500,000, you will owe $0 in capital gains taxes upon sale (other taxes, like local excise taxes, still apply).
A good question to ask here is, “How do I calculate my gain?” In short, it’s the difference between your sales price and your cost basis. Note that I didn’t say, your sales price minus the price you paid. The price you paid is just one element of your cost basis, and understanding this difference is at the heart of what we want to communicate today. So, how do you calculate your cost basis and why is it important?
To look at this, let’s take an actual example of a house on the market located a couple blocks south of where I live. Here’s the Redfin listing. It’s listed at a cool $995,000. Browsing the listing, you will see that it last sold for $393,200 in June 2004. That’s a difference of $601,800.
For the purposes of this exercise, let’s assume the following:
- The owners occupied this house (rather than rented it out) for at least 2 of the last 5 years.
- The owners are married and file taxes jointly.
- The owners pay a 15% capital gains tax rate (could be as high as 23.8%, depending on other income).
- We’ll also unrealistically assume they only got what they listed it for, rather than some ridiculous $300,000 over asking price 😊.
Knowing this, let’s take a quick quiz…
- Does this seller owe capital gains taxes on a $601,800 gain? (Answer: No)
- What would their taxable gain be, assuming no other adjustments to their cost basis? (Answer: $601,800 - $500,000 = $101,800)
- What would their tax bill be if they paid taxes on this $101,800? (Answer: $15,270 at 15% rate…$23,228 if the 23.8% rate applied).
Is that the end of the story? Of course not. This wouldn’t be worth writing about if it was! Our job here to help you realize ways to bring that $15,270 bill down to $0. How might you do that? One option is to sell your house for less, but that’s pure foolishness. That’s a classic case of “spend a dollar to save a quarter” (or 15 cents, in this case). Instead, the answer is to increase your cost basis (legally, of course!). So, how do you go about increasing your cost basis?
Let’s start with the easy one. Any costs associated with selling the home get added to your basis. This includes things like real estate commissions, staging, and closing costs. Continuing our example, let’s see how these help our sellers:
That certainly helped. We’ve already brought the tax bill down by $10,305. However, our goal is to get it below $0. You’ll see there is still $33,100 of taxable gain. How might we eliminate that? We need to further increase the basis, which we can do by including the cost of any “permanent improvements” the sellers made to the home while they lived there. A permanent improvement is anything that “adds to the value of your home, prolongs its useful life, or adapts it to new uses.” The IRS provides a very helpful chart on this in Publication 523 that we provided a link to earlier. Here it is:
Coming back to our example, let’s assume the sellers completed the following improvements during their 17 years living there:
If you are a homeowner, you are probably thinking – that’s all they did? What about fixing the leaking toilet and painting the exterior? In general, repairs cannot be included in your cost basis. However, if these “repairs” were done as part of an extensive remodeling or restoration of your home, they do count. The oft-cited example here would be that you can’t include replacing a broken windowpane, but you can include replacing the same window as part of a project of replacing all the windows in your home (this is an “improvement”).
Anyway, let’s get back to that $35,000 of improvements. Let’s add these to our earlier calculations and see what happens:
We did it! We went from a $15,270 tax bill to $0. Note that you cannot take a capital loss on the sale of home (different story for a rental property, but we won’t get into that here). We’ll finish by saying, “Keep good records.” Ideally, you keep receipts for these “improvements.” In practice, that can be difficult, but the IRS is technically looking to see an invoice and a banking record to support that you actually paid that invoice. A banking record could be a canceled check, bank statement, credit card statement, or some other document showing the amount was actually paid. Reality is that you may not have this for any number of reasons. You can still claim the expense. Just know that the IRS may disallow the deduction should you get audited.
One bonus note – if you live in states like Washington where you can take an itemized deduction for sales taxes paid, you can annually write-off the cost of sales taxes paid on major home improvements. If you do (which you should), you just can’t include those sales taxes paid in your calculation of your cost basis (that would be double-dipping!). Likewise, if you take a tax credit for things like energy improvements (very common these days), you must subtract those credits or subsidies from your total basis.
I sincerely hope this helps you to better understand the landscape of taxation when selling your home. By no means is this an exhaustive discussion, and we invite you to discuss with us the specifics of your situation as you think about selling your home in the future.