Until the past few years, homeowners had a simple solution when the home was no longer big or nice enough: trade up. Now, with the housing market in the doldrums, it may make more sense to improve or expand the home you already have, and that makes good recordkeeping essential.
That’s because some types of investments in your primary home can affect a tax bill you might receive after selling the home at a profit. Although most homes don’t fetch enough to trigger a tax bill, having good records could make life a lot easier if the IRS wants to know how much you made.
The basic rules, on the books since the 1990s, are pretty straightforward. Profits are taxable only to the extent they exceed $500,000 for a couple filing a joint return, or $250,000 for an individual. You’d have to own a pretty expensive home, or have had it for a very long time, for profits to pass those thresholds, although it does happen.
Gains above those levels are taxed as long-term capital gains, at a rate no higher than 15%. To get the full exemption, you must have lived in the house for two of the five years before the sale.
Calculating profits is trickier than just subtracting the purchase price from the sales price. Some expenses can be added to the purchase price, or subtracted from the sales proceeds, while others cannot. For details, look at IRS Publication 523.
The sales price, or “amount realized,” is the sales price minus sales expenses such as advertising and realtor’s commission.
In much the same way, certain fees involved in buying the home can be added to the cost. This includes things like title insurance and fees for surveying the land or having utilities hooked up. It does not include things like property taxes, homeowner’s insurance or moving expenses, or costs incurred in getting a mortgage, like the loan application fee.
As if that’s not complicated enough, many major improvements can be added to the cost, but routine maintenance cannot. In addition, a new bathroom, new deck or patio can also be added to the cost, along with permanent landscaping, a pool, a new water heater, built-in appliance or roof, and many others.
Although permanent improvements are likely to increase your eventual sales price, most improvements do not pay for themselves when the property is sold. In many cases, that means improvements can actually reduce the chance you’ll be subject to tax, by narrowing the gap between proceeds and cost.
But if you neglect to account for the cost of major improvements, they will enhance the chance of triggering a tax, since they will boost the sales price.
Of course, these are the rules today, and who knows how they might change over the decades you might own your home. The long-term capital gains rate may go up as early as next year, after the Bush-era tax cuts expire. Congress and the Obama Administration are wrestling with tax issues now.
So here’s the bottom line: Keep all records of money spent on your home, except for the most mundane costs, like cleaning supplies. Also, take a close look at Publication 523, as there are special rules for people who inherit homes or take them on during divorce.