by Dave Horwedel, EA
Minimizing Tax on Sale of a Home
If you’re looking to sell your home, you should take a close look at the exclusion rules and cost basis of your home to reduce your taxable gain on the sale.
You are welcome to contact Torchlight Tax if you would like our assistance in minimizing your tax hit legally.
The IRS exclusion rule allows an exclusion of gain up to $250,000 for a single taxpayer or $500,000 for a married couple filing jointly. This exclusion can be used over and over during your lifetime (but not more frequently than every 24 months) if you meet the ownership and use tests.
Your basis is generally your cost in acquiring your home plus the cost of any capital improvements you made, less casualty loss amounts and other decreases.
You have a gain on the sale when your sale price exceeds your basis when you sell.
Determining Eligibility for the Exclusion Rule:
During the five-year period ending on the date of the sale, you must have:
- Owned the home for at least two years – Ownership Test
- Lived in the home as your main home for at least two years – Use Test
- Not excluded gain from the sale of another home during the two-year period ending on the date of the sale.
The Ownership and Use periods need not be concurrent. Two years means 24 months or 730 days within a five-year period, but the months or days need not be consecutive. Short absences, such as for a summer vacation, count in the period of use. Longer breaks, such as a one-year sabbatical, do not.
If you own more than one home, you can exclude the gain only on your primary home.
The exclusion can be used repeatedly when you reestablish your primary residence.
Only taxable gain on the sale of your home needs to be reported on your tax return.
Improvements Increase the Cost Basis
Be sure to consider all improvements made to the home over the years when selling your home. Improvements will increase the cost basis of the home, thereby reducing the capital gain.
Additions and other improvements that have a useful life of more than one year can also be added to the cost basis of your home.
Examples of such improvements include the following: building an addition; finishing a basement; putting in a new fence or swimming pool; paving the driveway; landscaping; or installing new wiring, new plumbing, central air conditioning, flooring, insulation, or a security system.
Here is an example: Bob and Gisela purchased their primary residence in 2010 for $250,000. They built an addition, added a swimming pool, and made several other home improvements adding up to a total of $80,000. The adjusted cost basis of the house is now $330,000. The married couple sold the house in 2023 for $600,000. It cost them $40,000 in commissions, advertising, and legal fees to sell the house.
These selling expenses are subtracted from the sales price to determine the amount realized. The amount realized in this example is $600,000-$40,000=$560,000. That amount is then reduced by the adjusted basis (cost plus improvements) of $330,000 to determine the gain. The gain, in this case, is $230,000.
Taking into account the exclusion, there is no taxable gain on the sale of this primary residence and, therefore, no reporting of the sale on Jack and Mary’s 2023 joint income tax return.
However, if you receive form 1099-S on the home sale, you must report the sale on your tax return and do the calculation. If the sale is reported to the IRS with a form 1099-S, they will expect to see it on your tax return.
If they do not see it, they are likely to decide the sale price is all profit and there is no exclusion you are eligible for. In this case, they would probably calculate taxable income of $600,000.
I have had new clients come to me with situations like this, where they had a huge tax assessment from a prior year with a home sale. We were able to handle it successfully, after some bacik-and-forth with the IRS.
It would have been a lot simpler if they had come to us when the house sold and given us the 1099-S. It is much easier to file a tax return properly in the first place, then handle it in an IRS Audit.
Partial Use of the Exclusion Rules
Even if you do not meet the ownership and use tests, in certain circumstances you may be allowed to exclude a portion of the gain realized on the sale of your home. A partial exclusion may be available if you sold your home because of health reasons, a change in place of employment, or certain unforeseen circumstances. Examplea of unforeseen circumstances include divorce or legal separation, natural or man-made disasters resulting in a casualty to your home, or an involuntary conversion of your home.
Good recordkeeping is essential for determining the adjusted cost basis of your home. Ordinarily, you must keep records for three years after the filing due date. However, you should keep documents proving your home’s cost basis for as long as you own your home.
The records you should keep include:
- Proof of the home’s purchase price and purchase expenses
- Receipts and other records for all improvements, additions, and other items that affect the home’s adjusted cost basis
- Any worksheets or forms you filed to postpone the gain from the sale of a previous home before May 7, 1997.
Do you have tax questions or situations?
If so, you are welcome to contact Torchlight Tax for a free consultation by calling 1 (877) 756 7797 or emailing info@TorchlightTax.com.
Our job is to save you tax dollars by doing your taxes correctly and without cheating or putting you at risk. We are also here to answer your questions and make the whole tax process as painless as possible.