Residential real estate prices nationwide have rebounded sharply since bottoming out in early 2012. The Case-Shiller National Home Price Index, for example, increased 38.2 percent by the end of last year from the 2012 trough. The index is now above its previous peak, recorded in July 2006.
The recovery in home prices means that homeowners looking to sell their primary residence need to be alert to steps they can take to eliminate or minimize capital gains taxes on the sale.
Refresh my memory, how does the IRS define capital gains? When the value of an asset, such as a home, is higher than what the owner paid for it, the difference in value is called a capital gain. The gain is not realized until the asset is sold. When sold, the capital gain is classified as either short-term (meaning the asset was held for one year or less) or long-term (held for more than one year). The asset owner must include realized gains, netted against realized capital losses, in their income tax return and pay any associated capital gains taxes. Many asset owners with long-term capital gains are likely to have federal tax liabilities equal to 15 to 20 percent of the gain.
But residential home owners get a valuable tax benefit. There are special rules around home sales and capital gains, which are very different from how capital gains on stocks, bonds, and mutual fund are treated. The IRS grants taxpayers selling their primary residence an extremely valuable capital gain exclusion. For a single tax payer, up to $250,000 of capital gains on the sale of their primary residence are tax free, while for a couple, they can exclude $500,000.
Are there any restrictions on the benefit? The home must be the primary residence of the taxpayer for at least 2 out of the past 5 years. But there are no limits to the number of times a taxpayer can take advantage of this important tax benefit. In a rising housing market, taxpayers who move frequently can sometimes rack up substantial gains that are shielded from capital gains taxes.
For homeowners with capital gains over the exclusion amount, any tips for reducing capital gains taxes? There are 3 strategies that homeowners should be aware of, from simple techniques to one that requires more planning.
1. Home improvement costs increase your basis. From the perspective of the IRS, home improvements like adding a deck, a pool, or landscaping the property, add to the value of your home. Keep track of these expenses because taxpayers can add the sum incurred over the years to the original cost of the home, to come up with a revised cost basis for the house. This reduces the amount of capital gains on the sale, thereby reducing any capital gains tax bill.
2. Selling expenses lower your sale proceeds. Expenses like broker commissions, advertising and appraisal fees, and transfer taxes can be used to lower the sale value of the home, which reduces the gain on sale.
3. Evaluate keeping the home so heirs can benefit from a step-up in basis. Tax laws are notoriously complex. But there is an important wrinkle associated with estate taxes that creates an important tax planning tool for home owners. When someone dies, the IRS permits assets owned by the deceased to pass to their heirs at the then current market value, without being liable for any capital gains taxes. For example, suppose a homeowner purchased a home many years ago for $500,000 and it is now worth $1.7 million. If she elected to sell the home during her lifetime, she would then have a gain of $950,000 that would be subject to capital gains taxes (the gain is equal to the $1.2 million appreciation less the $250,000 exemption). Assuming the seller is in a high-income tax bracket, she would likely be subject to a capital gains tax of approximately 20 percent on the sale, or $190,000. But if instead the homeowner remained in the house until she passed away, it would pass to her heirs at $1.2 million, with no capital gains being due on the transfer.
NOTE: Nothing in this post should be considered as rendering legal or tax advice for specific cases. Readers should be sure to discuss their specific circumstances with their financial and tax advisors before taking any action.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.