COVID-19 has enhanced both the work from home and schooling from home models. More and more people are looking at redesigning their current home and/or buying a new home due to lifestyle changes, and with employers encouraging the work from home concept, people are looking to migrate to the suburbs from city centers.
Let’s say you have been offered an attractive price for your current home. Over the years, you’ve probably put a ton of money into your home—that new roof in 2013, the deck you added in 2014, and the nightmare that was a kitchen remodel in 2017. While those costly improvements didn’t net you any tax benefits back when they were done, we hope you kept those receipts and records! We’ll get back to that in a bit.
Let’s say you purchased your home when the market was low, around 2012. Now you’re ready to sell and recoup your investment. Will there be a big tax bite on the gain? Probably not, if you’ve lived in the home as your primary residence for two of the last five years. If you meet this time requirement, your first $250,000 of gain (if single) or $500,000 of gain (if married—the rules are a little more complicated if there’s been a divorce) are not subject to federal income tax under current law. Also, this exclusion is available to take more than once, but not more often than every two years.
Back to our example, if you are single and managed to get a fantastic deal on your house (perhaps a foreclosure) in 2012 for $125,000 and were lucky enough to see your investment appreciate over the years and now you have been offered $399,000. That is a gain of $274,000 and doesn’t that put you over the exclusion? Not necessarily. This is where having your receipts and records from all those improvements comes in handy. Your basis (investment on which the gain is calculated) in the home includes your purchase price plus any improvements. Also, the costs associated with the sale (such as real estate commissions) are deducted from the sales price. Once you re-do the math with these additional figures, your gain could very well be below the $250,000 threshold and therefore, is tax-free as illustrated below:
Keep in mind that not all the money you put into your home “counts” as an increase to your basis. Normal repairs and maintenance (such as painting, fixing plumbing leaks, repairing broken steps) should not be considered. Nor should improvements that are no longer part of the home, such as wall-to-wall carpeting that you installed but later replaced with hardwood flooring. In that case, the hardwood flooring, but not the carpet, would be added to the basis. A common misconception is that you can include the value of your time for do-it-yourself projects, but this is specifically not allowed according to the tax laws (sorry, DIY-ers!). Items that can be included typically increase the home’s value, such as appliances that are left with the home upon sale, decks, flooring, additions, doors and windows, fences, siding, heating and air conditioning systems, driveways, security systems, and kitchen and bath modernizations.
If you meet the requirements for living in the home for two of the past 5 years, but your gain is above the $250,000/$500,000 limit, only the excess is subject to tax at preferential capital gains rates.
This represents a basic overview of the tax law as it applies to the sale of a primary residence. There are many situations that call for additional analysis in the year the home is sold, such as:
- The home was previously a rental property or used for business
- The home was received through a divorce settlement, gift or inheritance
- The homeowner meets an exception to the two-year rule
- The homeowner qualifies for a reduced exclusion
- The home was acquired through a like-kind exchange
- The homeowner had received any tax credits or subsidies that may be subject to recapture
Since a home is often the largest asset and most significant portion of a taxpayer’s net worth, this exclusion offers a meaningful tax break and acts as an incentive to homeownership. Keep in mind, however, that tax laws can and do change. For this reason, we recommend keeping excellent records of all improvements to justify your basis in the property even if you don’t think your gain will approach anywhere near the threshold amount.
If you have any questions regarding the tax implications for selling your home, please reach out via email, give us a call at (401) 921-2000, or fill out our online contact us form.