What is Your “Tax Basis”?
Your tax basis is the cost of buying, building or improving a property. For example:
- Purchase Price: $500,000; PLUS:
- Closing Costs: $10,000; PLUS:
- Home Improvement Costs throughout the Years: $100,000; EQUALS:
- Tax Basis: $650,000
What is Your “Capital Gain”?
Your capital gain on the sale of the property is your sales price MINUS your costs of sale MINUS your basis. For example:
- Sales Price: $1,000,000; MINUS:
- Costs of Sale: $80,000; MINUS:
- Tax Basis: $650,000; EQUALS:
- Capital Gain: $270,000
What is the “Capital Gains” Tax?
In the US, we’re required to pay capital gains taxes on any profit (“capital gain”) we receive when we sell a property. Under current law, the capital gains tax rate can be up to 20%, plus an additional 3.8% net investment income tax. Using the example above, you could be required to pay up to up to $64,260 in capital gains taxes (23.8% tax on the $270,000 of capital gain), depending on your specific income level.
What is the “Primary Residence Exclusion”?
If the property is your primary residence, you can get what’s called a principal residence exclusion. This means that a certain portion of the capital gain is excluded from tax. Married couples can exclude $500,000 of capital gain from tax. Individuals or married couples filing a separate tax return can exclude $250,000 of gain from tax. In the example above, the entire $270,000 would be excluded from tax if this was your primary home and if you were married, filing a joint tax return. This means that you could save up to $64,260 by using this exclusion (no capital gains tax and no 3.8% investment income tax)! Here are several rules to follow to qualify for the exclusion:
- You must live in the home as your primary residence for 2 out of the last 5 years.
- You can take the exclusion once every two years: If you have a large capital gain on your property, why don’t you consider selling it now, and pocketing the proceeds tax-free? Then, you can purchase another home and do it all over again because there’s no limit on how many times you can get this exclusion! You just have to wait 2 years in between each sale and make sure that you live in the property as your primary residence.
- You don’t have to use the proceeds to buy another home.
- The exclusion only applies to primary homes: This exclusion doesn’t apply to vacation homes or investment properties. It only works if you live in a property for two full years out of the last five full years. Also, there are some limitations on the exclusion if you turn a rental property into a primary home.
- Extra calculation applies if you convert a rental property into a primary home: If you rent out the house BEFORE you live there as your primary residence, the calculation of how much gain you can exclude is based on the percentage of time that you’ve lived in the home as your primary residence. For example, if you rent out the house for three years, and then you move in and live in the house for the next three years, you can only exclude 50% of the gain. This is because you only lived in the house for 50% of the time you owned it. This calculation must be performed even if you originally bought the house as a primary home, but didn’t live there until after you rented it out. However, if you rent out the house AFTER you’ve lived in it as your primary home, you do not need to perform this extra calculation.