People sometimes get confused about how the capital gains tax exemption applies when it comes to selling a home. It’s worth understanding because it can have a huge impact on your proceeds.
Capital gains tax is the tax on profits realized when you sell an asset such as stocks, bonds, precious metals, real estate, and other property. As a rule, the higher the profit, the higher your tax liability will be. However, in some cases, the government provides an exemption to reduce your tax bill.
When it comes to real estate, homeowners with single-family homes can benefit from a significant exemption as long as they’ve lived in the home for at least two of the last five years. Single (unmarried) homeowners are allowed to exempt the first $250,000 worth of profit. Married homeowners who file joint tax returns are allowed to exempt the first $500,000 worth of profit. (Tempting as it may be, I do not recommend getting married simply for the tax deduction.)
Profit is calculated as follows: the sales price minus the sales costs minus the acquisition cost plus the cost of improvements. Acquisition cost includes the purchase price as well as escrow fees and title insurance. In some cases, it also includes the cost of inspections and up-front repairs paid through escrow.
Improvements are not the same as maintenance. Improvements are the expenses associated with things like a new roof, a room addition, or new solar panels. From a tax standpoint, improvements are of a more permanent nature. They do not include maintenance costs like fixing a leaky faucet or replacing a cracked window.
The sales price is the amount noted in the closing statement from the escrow company minus the cost of the sale, which typically includes some escrow expenses and the brokerage fee, but also expenses immediately prior to the sale incurred for the specific purpose of increasing marketability (new carpet, paint, and landscaping, for example).
So, let’s say you bought your home more than ten years ago for $500,000 and spent another $5,000 on repairs paid through escrow plus standard escrow fees and title insurance expenses. Your acquisition cost would be $505,000. Note: the amount you owe on the loan is not considered when calculating the profit.
As of a couple of years ago, the home’s value had increased to $1 million, so you refinanced it for $800.000 at an interest rate of 2.5%. Now, you decide to sell the house for $1 million. You’ve paid your loan down to $750,000, so when you sell, you get cash of $200,000 ($250,000 minus sales costs which happen to be $50,000 in this case). However, your profit is calculated at $1 million minus the sales cost and the acquisition cost of $505,000. Your profit is $445,000. You’re single, so your exemption is $250,000. This means you owe capital gains tax on the remaining $195,000. That will amount to roughly $65,000, or a third of the profit, so you’ll walk away with $135,000 (which is the cash minus the tax liability). If you’re married, you won’t pay any capital gains tax, so you walk away with $445,000.
If your gain outstrips your exemption, consider an installment sale. In this scenario, you carry some or all of the financing for the buyer of your property, and you only report the gain as you receive the down payment and principal payments on that loan. You will still pay taxes on the entire gain eventually, but you’ll spread it out over time, and perhaps your tax bracket will change during that period, which would affect the taxes you owe. Also, in an installment sale, you collect interest on money that you would have otherwise paid to the government in the form of capital gains taxes. So, if you don’t need the sale proceeds in a lump sum, this could be a good way to go.
It’s been more than 30 years since these capital gains tax exemptions for single-family homes were established. Inflation has changed the value of those numbers a lot, so those of us paying attention believe the federal government and state governments should revise the amounts to adjust for inflation and then index them so the amounts go up and down with inflation automatically.
If you have questions about property management or real estate, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.