The phrase "capital gains tax" has the power to create fear in the heart of many homeowners, especially those with plans to sell in the near future.
If you are planning to sell your home soon and already worrying about your capital gains liability, the information in this article can help you understand the meaning of the law, and help you determine how, or if, the capital gains tax will affect you with the sale of your home.
What is the Capital Gains Tax?
As the Internal Revenue Service (IRS) explains, nearly everything owned or used for personal or business use is considered a capital asset, including your home and even your furniture and other personal possessions. Capital gains taxes are calculated by computing the difference of the basis (usually the original purchase price) of the home or item being sold and its current value at the time of the sale.
Unlike most other possessions that tend to go down in value - like your car or your dishwasher - homes are more likely to go up in value through years of ownership. When the time frame between the home's purchase and its sale is only a few years and the home was originally purchased at fair market value, the difference between the initial cost and the sale price may not be enough to trigger capital gains taxes, as they are currently written.
But if the home was inherited or has been owned for many decades, the difference is likely to be far larger and much more apt to result in triggering the capital gains tax.
Fortunately, some costs of home ownership, such as renovations, can be used to offset the difference between the two figures and lessen the burden of any applicable capital gains tax. Since tax laws are frequently altered, sellers should always consult with a reputable tax professional to be sure they are in compliance with all tax laws when selling a home.
What Should Sellers Know About the Exemptions?
Currently, there is a tax break that exempts individuals from $250,000 of capital gains liability when selling their primary residence, with couples exempt from twice that amount, or $500,000, but specific rules apply before this exemption can be used. These rules include both ownership and usage guidelines, which currently include provisions stating that the seller must have owned and used the home as their primary residence for an aggregate period of at least two years of the five years immediately preceding the sale of the home.
What is the Most Common Mistake That Home Sellers Make?
One of the most common mistakes that sellers make in regards to the capital gains tax is the failing to keep good records and retain receipts for expenditures for renovations or improvements and other costs while living in the home. These records, if they have been properly retained or recorded, can be used to offset the difference between the basis (price paid) and the sale price, thus lowering the amount of applicable capital gains tax on the sale.
When sellers factor in the average cost to replace a roof or buy a new HVAC system, the importance of keeping track of these expenses becomes very clear.
Even if you have not retained receipts for renovations or improvements, you may still be able to use some of these expenses to offset your capital gains responsibility if you can provide other documentation proving the work was performed.
Other types of documentation that may be helpful in proving these expenses, including:
- credit card statements
- bank statements
- copies of canceled checks used to pay for materials or labor
- copies of permit applications that spell out the scope of the renovations that were completed
- copies of inspection reports done in conjunction with the permit process that specify the renovations that were made to the home
- contractor bid forms
- changes to your homeowner's policy that reflect significant improvements were made in the home
- dated photos of the construction or renovation process
Tax laws and regulations tend to change through time and home sellers should be aware of this possibility. Homeowners who plan on putting their home up for sale in the near future could benefit from discussing their tax situation with a reputable tax attorney or certified professional accountant (CPA) before moving forward to list the home.
If you do not currently have a relationship with a tax attorney or CPA, your real estate professional can refer you to a reputable professional who can give you current, credible advice about capital gains tax law and how it will apply to your situation.