Capital Gain Tax Exclusion and Home Sale Tax Laws to Know

Residential real estate prices in many markets have surged over the last few years. As a homeowner, you may be sitting on a significant unrealized gain, especially if you’ve owned your principal residence for a while. That’s good news if you’re ready to sell, but will you owe taxes on the profit when you sell?

Thankfully, the federal income tax gain exclusion break for principal residence sales remains a potentially big tax-saver for home sellers. If you’re unmarried, the exclusion can shelter up to $250,000 of home-sale gain, and it rises to $500,000 for married couples who file jointly.

Your taxable gain equals the difference between the net selling price and your tax basis in the home. If you’re fortunate enough to have a gain that exceeds what you can shelter with the home-sale gain exclusion, you can whittle down your gain by deducting allowable selling expenses. You can also lower your gain and increase the tax basis in the home by adding the costs of eligible improvements. Here’s a closer look at what’s included and excluded from tax basis in a principal residence.

Ownership and Use Tests

To take full advantage of the principal residence gain exclusion, you must pass the following two tests:

1. Ownership test. You must have owned the home for at least two years out of the five-year period ending on the sale date.

2. Use test. You must have used the home as your principal residence for at least two years out of the five-year period ending on the sale date.

Important: These tests are completely independent. In other words, periods of ownership and use don’t need to overlap. For purposes of the tests, two years means periods aggregating to 24 months (730 days).

Special Considerations If You’re Married

If you’re married and file jointly, you qualify for the bigger $500,000 joint-filer exclusion if:

• Either you or your spouse pass the ownership test for the property, and
• Both you and your spouse pass the use test.

If you’re married and you and your spouse file separately, you can potentially qualify for two separate $250,000 exclusions for your respective shares of the gain if you both independently pass the ownership and use tests.

Important: There are special rules for unmarried surviving spouses, as well as an anti-recycling rule that prevents you from claiming a home-sale gain exclusion if you’ve claimed it for an earlier gain within a two-year period ending on the date of the later sale. Contact your tax advisor for more details.

Costs from When You Bought the Home

You can increase the tax basis of your home by including eligible buyer closing costs from when you purchased the home. Examples include:

• Survey fees,
• Abstract of title fees,
• Legal fees, including fees for the title search and preparing the sales contract and deed,
• Recording fees,
• Transfer or stamp taxes, and
• Owner’s title insurance.

However, you can’t include amounts placed in escrow for the future payment of items, such as property taxes, homeowner’s insurance and homeowners’ association (HOA) fees. You also can’t include prorated HOA fees that the seller essentially prepaid for periods after the closing date.

But you can include in your tax basis any amounts the seller owed that you (as the buyer) agreed to pay (as long as the seller didn’t reimburse you). Examples include:

• Property taxes owed up through the day before the sale date,
• Back mortgage interest owed by the seller,
• The seller’s title recording or mortgage fees, and
• Charges for improvements or repairs that were the seller’s responsibility but that you agreed to pay, such as mold or lead paint remediation expenses.

Examples of settlement fees and closing costs that you can’t add to your basis include:

• Homeowner insurance premiums,
• Rent paid to occupy the home before closing,
• Charges for utilities or other services related to your occupancy of the house before closing,
• Fees and charges connected with getting a mortgage loan, such as the costs of a credit report, the fee for an appraisal required by your lender, points paid to your mortgage lender, and mortgage loan origination fees.

You may be able to deduct mortgage points paid to the mortgage lender if you itemize deductions. Your tax professional can explain the details if this applies to your situation.

Construction Costs

If you contracted to have your home built on land that you owned, your initial tax basis in the home equals the cost of the land, plus the costs to construct the home. Those costs include:

• Labor and materials,
• Amounts paid to a contractor,
• Architect’s fees,
• Building permit charges, and
• Utility connection charges.

You’re also allowed to include any legal fees related to building the home.

Home Improvement Costs

Improvements add to the value of your home, prolong its useful life or adapt it to new uses. The costs of such improvements increase the tax basis of your property. Examples of improvements that increase the tax basis of your home include:

• New room additions,
• Garage expansions,
• Kitchen remodeling projects, such as new cabinets and countertops and new built-in appliances,
• Bathroom remodeling projects,
• Garage-to-bedroom conversions,
• New wall-to-wall carpeting,
• New patio or deck,
• New HVAC equipment, including duct work,
• New central humidifier or central vacuum,
• New air or water filtration systems,
• New security system,
• Permanent landscaping features, such as sprinkler systems, in-ground pools, driveways, walkways, retaining walls and fencing,
• New windows and doors,
• New roof, siding or insulation,
• New attic walls or floor,
• New septic system, and
• New water heater or soft water system.

Important: You can’t add basic repair or maintenance costs, such as the cost of replacing some roof shingles or new paint, to the tax basis of your home. However, you can add the costs of repair-type work if the work is done as part of an extensive remodeling or restoration job. For example, replacing a broken window is a repair, but replacing the same window as part of replacing all the windows in a remodeling project counts as an improvement. Similarly, painting is a generally repair, but if the work is done as part of a major remodeling effort, it counts as an improvement.

Work that simply keeps your home in good condition — without adding to its value or prolonging its life — is considered normal repair and maintenance. Examples of repair and maintenance items that are excluded from your home’s tax basis include:

• Painting the interior or exterior,
• Fixing leaks,
• Filling holes or cracks, and
• Replacing broken hardware.

You’re also not allowed to add improvements with a life expectancy of less than one year to the tax basis of your home.

Energy-Efficient Expenditures and Related Tax Credits

Congress has created and expanded several personal federal income tax credits for expenditures for eligible energy-efficient additions. Examples include:

• Solar electric generating equipment,
• Solar water heating equipment,
• Fuel cell equipment,
• Small wind energy equipment,
• Geothermal heat pumps,
• Biomass heating equipment, and
• Battery storage technology.

Qualified expenditures include costs for site preparation, assembly, installation, piping and wiring. You can add these costs to the tax basis of your home, but you must subtract the related tax credits from your tax basis. Eligible gear can be expensive, and allowable credits, which must be subtracted from basis, are usually significant.

More modest credits have been allowed for such items as energy-efficient windows, skylights, and exterior doors; specified heat pumps, heat pump water heaters, biomass stoves and boilers; and home energy audits. Once again, you can add these costs to the tax basis of your home, but you must subtract the related tax credits from your tax basis.

Important: If you claimed these credits, you should have filed IRS Form 5695, “Residential Energy Credits,” with your federal tax return for the year.

Seller-Paid Closing Costs

Technically, you’re supposed to add allowable seller-paid closing costs to the tax basis of your home in calculating your taxable gain. However, the practical effect is that allowable closing costs are simply deducted from the stated sale price in figuring the net sale price. It’s easier to think of it that way, especially since that’s how seller-paid closing costs are presented on your closing statement in arriving at how much cash you will receive.

Allowable closing costs that decrease your net selling price (and therefore decrease your taxable gain) include the following amounts you pay as the seller:

Sales commissions. The seller is usually responsible for paying sales commissions to the seller’s realtor and to the buyer’s realtor.

Seller concessions. These are amounts that you as the seller agree to pay to reduce what the buyer has to pay. For instance, you may agree to pay $25,000 towards the buyer’s closing costs for mortgage points or a painting allowance. In effect, seller concessions are simply discounts to the stated selling price.

Owner’s title insurance. In most, but not all, jurisdictions the seller is responsible for paying title insurance premiums. They can amount to thousands of dollars. You can also deduct from the stated selling price any other fees paid to the title insurance company at closing.

Prorated property taxes that the seller pays at closing. You can deduct these if you itemize subject to the $10,000 annual limit on combined state and local property and income taxes ($5,000 if you’re married and file separately).

Recordkeeping Is Essential

In summary, there are two ways to reduce your taxable gain on the sale of your principal residence. First, you can identify the eligible costs when you purchased the home and the costs of qualified home improvements you’ve made over the years and add them to the tax basis of the home you’re selling. Second, you can subtract allowable closing costs in calculating the net selling price that you receive at closing.

Taking the time to capture everything that reduces your taxable gain is well worth the effort. But you must have the proper records on hand from when you bought, built or improved your home to back up your calculations. Therefore, keeping accurate records for improvement costs is a smart practice for all homeowners. Contact your tax advisor if you have questions about your taxable gain on a recent or pending home sale.

Copyright 2024

This article appeared in Walz Group’s July 29, 2024 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.