Section 121, commonly called the Home Sale Tax Exclusion, requires that you owned and used the property as your principal residence for two out of the previous five years. This allows for a temporary rental of the property while still having the ability to qualify for the exemption. It can be claimed only once every two years.
Cost basis is determined by Purchase Price plus certain closing costs at acquisition plus capital improvements made to the home during ownership. Sales price, less selling expenses, is considered net sales price from which the cost basis is subtracted to arrive at capital gains on the sale.
If the capital gain is less than the applicable exclusion, no tax is owed. When the gain exceeds the exclusion amount, the overage is taxed at long-term capital gains rate which could be 0%, 15% or 20% depending on the taxpayer’s taxable income.
Capital improvements made to a home increase the cost basis and effectively, lower the gain in the sale. It is important for homeowners to keep records of the money they spend during the time they own the home.
Some improvements are apparent like a swimming pool, new fence, or roof but some are not so obvious. Replacing a faucet or a light fixture can be a capital improvement and even though the cost is small, lots of these items over the lifetime of owning the home add up.
The three rules for identifying capital improvements listed in IRS publication 523 are: 1) does it materially add value to the property? 2) does it extend the useful life of the property? 3) does it adapt a portion of the home to a new use?
While taxpayers are allowed to reconstruct a register of the improvements made during the time they owned their home, some things will undoubtedly, be overlooked. It is much better to have a written record of all money spent on the home in a contemporaneous manner and keep receipts for items over $75.
When you are ready to make the capital gain determination, you’ll save time and probably pay less taxes having the list readily available, whether you do your taxes or have a professional do them. For how this affects your particular situation, I recommend that you check with your financial advisor.