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Understanding Capital Gains in Real Estate
When you sell a stock, you owe taxes on your gain, the difference between
what you paid for the stock and what you sold it for. The same is true with
selling a home (or a second home), but there are some special considerations.
What you paid for the home includes not only the original price, but also the
cost of many improvements, so hold on to your receipts!
What receipts to keep? | Calculate capital gains - the basics
It pays to work with an experienced Realtor. If your Realtor let you sell a house after you lived there less than two years, I hope they brought capital gains to your attention. Otherwise, you could be paying tax on $10,000 or more easily, and it could have been avoided.
A special real estate exemption for capital gains
Since 1997, up to $250,000 in capital gains ($500,000 for a married couple) on the sale of a home is exempt from taxation if you meet the following criteria:
- Owned the home for at least 2 years.
- Lived in the home as your main home for at least 2 of the past 5 years.*
Also note that as of 2003, you may also qualify for this exemption if you meet what the IRS calls "unforeseen circumstances" such as job loss, divorce, or family medical emergency.
* This may not apply if you are a member of the uniformed services or Foreign Service.
How to calculate gain - the basics
In real estate, capital gains are based not on what you paid for the home, but
on its adjusted cost basis. To calculate this, the basics are:
- Take the purchase price of the home: This is what the home sold for, not the amount of money you actually contributed at closing.
- To the purchase price, add the following things which also cost you:
- Cost of the purchase—including transfer fees, attorney fees, inspections, but not points you paid on your mortgage.
- Cost of sale—including inspections, attorney's fee, real estate commission, and money you spent to fix up your home just prior to sale.
- Cost of improvements—including room additions, deck, etc....
- The total you get from above is the "adjusted cost basis" of your home.
- Subtract this adjusted cost basis from the amount you sell your home for. That will be your capital gain.
For details see IRS Publication 523.
What receipts to keep?
The partial list below is from IRS Publication 523.
Some of the items may surprise you:
- Additions to your home, including: Deck, Porch, & Patio
- Heating & Air Conditioning: Furnace, Duct Work, Central humidifier
- Lawn & Grounds: Landscaping, Fence, Sprinkler system, Swimming pool
- Plumbing: Water heater, Filtration system
- Interior Improvements: Kitchen modernization, Flooring, Wall-to-wall carpeting
- Miscellaneous: Satellite dish, Security system, New roof
I recommend that you get a copy of IRS Publication 523 and read through it. After all, it is your money!
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