The exclusion of capital gains on the sale of personal residences is one of the biggest tax breaks individuals can qualify for.
The amount you can exclude is as follows:
- Single filers: $250,000
- Married filers filing jointly: $500,000
How to qualify
To qualify for the home sale tax deduction, you must pass the “two-out-of-five-years” tests: You must have lived in the home as your primary residence for at least two of the past five years. They do not have to be consecutive. For example, you can occupy a home for a year, then move out for three years and turn the home into a rental, and then move back in for a year prior to selling the home, treating it as your primary residence for one more year prior to selling it. You would still meet the “two-out-of-five-years” test.
If you divide your time between two or more homes, the one where you spend the majority of your time will determine which home you are treating as your permanent residence.
Also, short absences of a temporary nature do not normally count against you for the purposes of claiming the exemption. Snowbirds can still spend winters in Miami without losing the tax break.
Claiming a partial deduction.
You may be able to claim a partial deduction if you sell before the full two years under certain circumstances, including changing jobs or a medical issue. If this occurs, the deduction would be prorated based on your use.
Mitigating the tax on ‘jumbo’ Gains
There are some cases where capital gains overwhelm even the generous $250,000/$500,000 exemption. When this happens, it is important to keep careful records on all your home improvement costs. Some homes that were bought years ago for $100,000 are selling for a million, in some highly appreciated markets. Situations like this can leave sellers with a very nasty surprise: A five or six-figure tax bill.
Careful recordkeeping is the key to mitigating the damage. Document every possible cost related to home improvement and renovation. The goal: Raise your (provable) tax basis in your home as high as you can get it. Since capital gains tax is calculated from the difference between your tax basis and the sale price, increasing your basis decreases your eventual tax liability.
Try to document all these expenses over the years:
- Rewiring to meet electrical code
- Replacing pipes
- Lead paint removal
- Installing LED lighting
- Adding a deck, patio, and/or a pool
- Adding a Florida room
- Adding a fireplace
- Bathroom/bedroom/kitchen renovations
- Labor costs on all renovations or improvements not already accounted for in the invoice
- Costs of pulling a permit
- Installing hurricane shutters
- Installing insulation/insulated windows
- Fireproofing projects
- “Mancave” renovations
- Installing new flooring or siding
- Re-roofing costs
Do not limit your thinking to direct material and labor costs paid directly to contractors. You can and should also add these items to your tax basis, as applicable:
- Closing costs
- Attorney/transaction fees
- Commissions paid to a broker or buyer’s agent
- Title searches and title insurance
- Permits pulled for improvements
- Deed recording fees
- Mortgage recording fees
You can find these items on your HUD closing statement you received when you purchased the home.
Maintaining careful records of all your home improvement and renovation costs can shave thousands off of your eventual tax bill when selling a highly appreciated home.
To find these expenses, dig through your old checkbooks, checking account statements and credit card statements.
It is a great idea to keep a logbook or file of all your home repair and improvement transactions, along with invoices and receipts.
These tips work equally as well for investment properties, too. In fact, it is arguably even more important, since investment properties don’t qualify for the capital gains exclusion – although you can put off the tax bill by rolling into a like-kind property in a Section 1031 exchange. That does not apply to personal residences, however.
Bear in mind that only renovations and improvements that were capitalized – that is, amortized over time – will increase your tax basis in the property and therefore reduce your capital gains tax. Repairs on personal residences that do not improve the value of the property, but only restore the property to its normal and usual function, are not deductible, and will not increase your tax basis. These are personal expenses.
Likewise, repairs on investment property for which you already took an immediate tax deduction will not increase your tax basis at sale. You already got the tax benefit of that transaction when you took the current year deduction when you did the repair.
Bear in mind that with investment properties, your basis will be reduced by any depreciation you claimed along the way.