We seek to save, even while spending. With a little estate planning, we can continue this trend by saving on the tax imposed on the sale of our main home. It is understood that most of us do not currently pay taxes when our homes are sold, which is due to an exclusion that is given by the government. This exclusion is limited, though, and without some attention we, or our loved ones, could inadvertantly pay a significant tax on something that could have easily been avoided.
The Absolute Basics
The amount of federal tax on the sale of someone’s primary residence is determined by taking the amount realized (the proceeds from the sale of the home) and reducing it by the adjusted basis (the cost of the home). If the difference is a positive number, then there is a gain and a gain is treated as income, which can be taxed.
On the other hand, if the difference is a negative number, then there is a loss. Typically, losses can be deducted from taxable income, which reduces the amount of income taxed. However, a loss taken on the sale of a primary residence cannot be deducted from taxable income. For this reason, this article will not further contemplate losses.
Due to a gain exclusion (which will be covered below), tax is normally not paid on the sale of a primary residence. In order to talk about a gain exclusion, we have to talk about gain and in order to figure gain, we have to talk about adjusted basis.
Determining Adjusted Basis
Adjusted basis is the benchmark of an investment. It is the point of reference when determining the cost of an investment, which is further used to determine whether the value of the investment went up or down.
The first factor in the adjusted basis calculation is to determine how the owner got the home. If the owner bought it or built it, then the adjusted basis is the cost of the purchase (down payment and loans) or build (cost of construction). If the owner got it as a gift, typically, the adjusted basis is the same as the previous owner’s. If the owner got it as inheritance, typically, the adjusted basis is the fair market value of the home on the date of the decedent’s death.
NOTE: If you owned your home jointly with your spouse and your spouse has passed, your basis in the home will change. The new basis for the half interest that you receive from the deceased spouse will be one-half of the fair market value on the date of death. The basis in your half will remain one-half of the adjusted basis determined from the initial adjusted basis. Your new basis in the home is the total of these two amounts. An example from the IRS website follows:
Your jointly owned home had an adjusted basis of $50,000 on the date of your spouse’s death, and the fair market value on that date was $100,000. Your new basis in the home is $75,000 ($25,000 for one-half of the adjusted basis plus $50,000 for one-half of the fair market value).
NOTE: Some basis situations are not contemplated in this article, such as adjusted basis when receiving property in a divorce settlement, adjusted basis when a home is built using insurance proceeds, etc. If you have a question about a certain basis situation, please contact an attorney.
The second factor is to add to the adjusted basis the costs of getting the home, called settlement fees or closing costs. These costs include installation of utilities, abstract of title fees, legal fees, recording fees, survey fees, transfer taxes, title insurance, certain real estate taxes, any amounts the seller owes that the buyer agrees to pay, etc. NOTE: not all settlement fees or closing costs may be used to adjust basis. If you have a question about a certain fee, please contact an attorney.
The third factor is to add to the adjusted basis additions and improvements to the home. In order to qualify as an addition or improvement that can be added to the adjusted basis, the addition or improvement must have a useful life of more than one year. This can include basic additions and improvements (new or improved bathroom, new or improved deck, new or improved kitchen, etc.), funds expended for special assessments for local improvements (a condo special assessment for a new roof), as well as amounts spent after a casualty to restore damaged property.
NOTE: there are several factors that decrease the adjusted basis that are not contemplated in this article, which may lead to greater gain (discharge of some or all of the debt incurred for purchase or development of the home, insurance payments for casualty losses, residential energy credits claimed, etc.). If you have a question about a certain deduction in adjusted basis, please contact an attorney.
Again, to determine the amount of gain, take the amount realized and reduce it by the adjusted basis. To calculate the amount realized, take the selling price and subtract any selling expenses and personal property that was sold with the home. Selling expenses can include real estate broker commissions, advertising fees, legal fees, etc. If you have a question about selling expenses, please contact an attorney.
How about a few examples?
Example One: Home Was Purchased Take the amount realized (let’s say the selling price was $505,000 and the amount of selling expenses and the personal property that was sold with the home is $5,000 ($505,000 – $5,000 = $500,000)), which is $500,000, and reduce it by the adjusted basis from the purchase (let’s say the house was purchased for $130,000, the settlement fees and closing fees total $3,000, and there was an extra room added for $17,000 ($130,000 + $3,000 + $17,000 = $150,000)), which is $150,000. The total gain on the home would be $350,000.
Example Two: Home Was Gifted During the Original Owner’s Life Assume the same amount realized from Example One ($500,000) and reduce it by the adjusted basis from the original owner, since the property was given during the original owner’s life (let’s say the original owner’s adjusted basis was $50,000 and there was an extra room added by the subsequent owner for $20,000 ($50,000 + $20,000 = $70,000)). The total gain on the home would be $430,000.
Example Three: Home Was Inherited Assume the same amount realized from Example One ($500,000) and reduce it by the adjusted basis, which would be the fair market value on the date of the previous owner’s death (let’s say the fair market value on the date of the previous owner’s death is $420,000 and there was an extra room added by the subsequent owner for $20,000 ($420,000 + $20,000 = $440,000)). The total gain on the home would be $60,000.
The Gain Exclusion
After calculating the gain, let’s explore the gain exclusion. To qualify for the gain exclusion, an owner must have owned the home for at least two years and lived in the home as the owner’s main home for at least two years during the previous five years. If the owner meets the exclusion, then the owner can exclude up to $250,000 if filing a single return, and $500,000 if married and filing a joint return.
Calculating the Tax
Let’s determine the tax of the previous examples for a single person and a married couple assuming a 15% long term capital gains tax:
Example One Gain was $350,000. A single person using the exclusion would have a gain of $100,000 and a tax of $15,000. A married couple using the exclusion would have a gain of $0 and a tax of $0.
Example Two Gain was $430,000. A single person using the exclusion would have a gain of $180,000 and a tax of $27,000. A married couple using the exclusion would have a gain of $0 and a tax of $0.
Example Three Gain was $60,000. A single person using the exclusion would have a gain of $0 and a tax of $0. A married couple using the exclusion would have a gain of $0 and a tax of $0.
Taking from The Examples
A quick analysis of the amount of tax in each example would yield the understanding that a higher adjusted basis, thus a lower gain, is key to minimizing tax. People will gift their property during their lives, which can be a big mistake (they are also gifting their assumably low basis). There are so many other easy ways to gift property, than just outright, that would carry the benefit of a stepped up basis and reduction of tax. A reduction that could possibly be several thousand dollars.
Please feel free to contact me for any further explanation of this article or to answer any questions; I am always happy to help.
Estate Planning Attorney