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The home-sale exclusion is one of the “biggest and best” tax breaks on the books. But it still may not be big enough if your home has appreciated substantially since you acquired it. Even if you qualify for the exclusion, you might owe a sizeable tax when you finally sell the place.
That is why it is important to keep good records of home-related expenses. These expenses often can increase your tax basis for home-sale purposes, reducing the taxable amount of a gain—if any.
Background: If you have owned and used your home as your principal residence for at least two of the previous five years, you can elect to exclude from tax up to $250,000 of home-sale profit if you are a single filer; $500,000 for joint filers. There are no limits on the number of times you can claim the exclusion.
The taxable amount for purposes of the exclusion is the difference between the selling price and the home's adjusted basis. For example, certain home improvements can increase the basis to cut down the taxable gain.
Example: The Johnsons bought their first home for $100,000 and sold it for $400,000. Then they acquired their current home for $450,000. Under the rules in effect at that time, they avoided current tax by rolling over the home-sale proceeds into their current home. During the last few years, the Johnsons added improvements costing $125,000. Now they are offering the home for sale at $750,000.
At first glance, it looks like no tax will be due on the home sale. Reason: The $300,000 profit ($750,000 less $450,000) is covered by the $500,000 home-sale exclusion for joint filers. But the actual basis after the sale of the first home is $150,000 (purchase price of $450,000 less deferred gain of $300,000). Even after the Johnsons claim the home-sale exclusion, they have a taxable gain of $100,000 ($750,000 minus $150,000 basis minus $500,000 home-sale exclusion).
If the Johnsons can document the $125,000 of home improvements, they can increase their basis to $275,000 ($150,000 plus $125,000). So the taxable gain comes to $475,000 ($750,000 less $275,000)—less than the $500,000 threshold. Thus, the entire gain is tax-free.
Practical approach: Maintain a logbook, ledger or other record of expenses you are adding to your basis. Keep the information stored in a safe place and make backup copies of the electronic files.
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