Capital Gains Tax Guide

Capital gains tax is a tax on the profit you may recognize when you sell an asset, including a home. Many homeowners may qualify to exclude some or all of the gain from the sale of a principal residence, but eligibility depends on the seller's ownership history, use of the home, prior exclusions, adjusted cost basis, improvements, depreciation, and other tax circumstances. Because every seller's tax situation is different, homeowners should confirm their eligibility and potential tax liability with a qualified tax professional.

Federal tax law may allow an eligible homeowner to exclude up to $250,000 of gain from the sale of a principal residence.

For certain married taxpayers filing jointly, the potential exclusion may be up to $500,000.

Eligibility for the larger joint-return exclusion involves additional requirements. In general, at least one spouse must satisfy the ownership test, both spouses must satisfy the use test, and neither spouse may have used the exclusion for another home sale during the applicable prior two-year period, subject to IRS rules and exceptions.

The exclusion applies to qualifying gain, not the gross sales price.

• IRS Topic No. 701 - Sale of Your Home
• IRS Publication 523 - Selling Your Home

In general, the federal principal-residence exclusion includes both an ownership test and a use test measured during the five-year period ending on the date of sale.

A taxpayer generally must have owned the home for an aggregate of at least two years during that five-year period, and used the property as a principal residence for an aggregate of at least two years during that period. The ownership and use periods do not necessarily have to be the same two years.

Additional rules apply to married taxpayers filing jointly, prior use of the exclusion, certain members of the uniformed services and other qualified officials, periods of nonqualified use, and other circumstances.

A homeowner who does not meet the full requirements may still qualify for a reduced exclusion in certain circumstances under IRS rules.

For tax purposes, a principal or main home is generally the home the taxpayer uses as their primary residence. When more than one property is involved, the IRS may consider facts and circumstances to determine which property is the main home.

Second homes, vacation properties, rentals, and properties with mixed personal/business use can involve different rules.

Sellers with more than one residence, rental history, business use, or unusual occupancy circumstances should discuss the facts with a qualified tax professional.

A property that was previously a rental, vacation home, or second home may potentially qualify for some exclusion if it later becomes the owner's principal residence and the applicable requirements are met. Special rules involving nonqualified use and depreciation can limit the exclusion, so sellers with mixed personal and rental use should obtain professional tax advice before relying on it.

When a property has both rental or investment use and principal-residence use, the capital-gains calculation can become significantly more complicated. Nonqualified-use rules and depreciation taken or allowable during rental periods may affect how much gain can be excluded. Gain attributable to depreciation can receive special federal tax treatment and generally cannot be excluded under the principal-residence exclusion. The applicable tax treatment depends on the seller's circumstances and should be calculated by a qualified tax professional. Because these calculations are fact-specific, sellers should work with a CPA or other qualified tax professional before relying on the principal-residence exclusion.

Tax basis is more complicated than simply adding every closing cost and every home expense to the original purchase price.

A home's adjusted basis may begin with acquisition cost and certain allowable acquisition expenses and may then be increased or decreased by specific adjustments under tax law.

Certain qualifying capital improvements may increase basis. Other items, such as allowable or allowable-to-have-been-taken depreciation, certain casualty-related adjustments, or other tax events, may reduce or otherwise affect basis.

Routine maintenance and ordinary repairs generally do not increase basis merely because the homeowner spent money on them.

IRS Publication 523 and Publication 551 provide general guidance, but sellers should have a tax professional determine their actual adjusted basis when the amount matters to the tax result.

• IRS Publication 523 - Selling Your Home
• IRS Publication 551 - Basis of Assets

Certain improvements that materially add value, prolong a property's useful life, or adapt it to new uses may affect the property's tax basis. Examples can include certain additions, major remodeling, structural improvements, major systems, or other qualifying work.

Tax treatment depends on the nature of the work and individual circumstances. Sellers should keep invoices, contracts, permits, canceled checks, and other records that may help substantiate qualifying improvements.

Routine maintenance and ordinary repairs generally do not increase the home's tax basis simply because money was spent. The distinction between a repair and a capital improvement can depend on the work performed and the surrounding circumstances. Keep records and ask a tax professional how a particular expense should be treated.

Your remaining mortgage balance does not determine your capital gain for income-tax purposes. The mortgage payoff affects how much cash you receive at closing, but taxable gain is generally calculated by comparing the amount realized from the sale with your adjusted tax basis. For example, two sellers could have the same sales price and the same tax basis but very different mortgage balances. Their cash proceeds would be different, but the mortgage balance itself would not reduce the capital gain calculation.

California generally conforms to the federal rules allowing qualifying taxpayers to exclude gain from the sale of a principal residence.

California does not provide a separate preferential tax rate for capital gains. Taxable capital gains are generally taxed as ordinary income under California's individual income-tax system.

Whether a seller owes California tax depends on the taxable gain and the seller's overall tax circumstances.

Consult the California Franchise Tax Board and a qualified tax professional for current guidance.

• California Franchise Tax Board - Income From the Sale of Your Home

A Section 1031 exchange can allow qualifying real property held for investment or business use to be exchanged for other qualifying like-kind real property while deferring recognition of certain gain. A principal residence does not qualify for a 1031 exchange simply because the owner plans to reinvest the proceeds into another home. In general, the replacement property must be identified within 45 days and acquired within 180 days, subject to the applicable tax-filing deadline and other requirements. 1031 exchanges have strict timing, documentation, qualified-intermediary, and property-use requirements. Sellers considering an exchange should involve a CPA, tax attorney, and qualified intermediary before the property closes.

Reporting can depend on the amount of gain, whether the entire gain is excludable, whether the seller receives Form 1099-S, prior use of the exclusion, and other tax factors. For example, a seller may receive Form 1099-S from the person responsible for closing the transaction in certain cases. A tax professional can determine whether the sale must be reported and which forms apply.

The amount of money a seller receives at closing is not the same as taxable capital gain. Cash proceeds are affected by mortgage and lien payoffs, transaction expenses, credits, and prorations. Taxable gain is based on federal and state tax rules involving the amount realized, adjusted basis, qualifying exclusions, depreciation, and other tax factors. A seller could receive substantial cash at closing and still have little taxable gain, or receive less cash and still have taxable gain. The two calculations serve different purposes.

Sellers should keep records that support their tax basis and improvements whenever possible. Useful examples may include the purchase closing statement, escrow documents, receipts, paid invoices, canceled checks, bank or credit-card records, contractor agreements, permits, improvement records, prior tax returns, and depreciation schedules for rental periods. If records are missing or incomplete, sellers should discuss acceptable documentation and reconstruction methods with their CPA or tax professional rather than relying on informal estimates.

Consider obtaining tax advice when the sale involves circumstances such as: substantial appreciation; uncertainty about cost basis; missing improvement records; rental or investment-property history; home-office or business use; depreciation; inherited property; property received through divorce or other transfer; multiple residences; prior use of the home-sale exclusion; sale before satisfying the full ownership/use tests; installment-sale considerations; a possible 1031 exchange; foreign-owner withholding; unusual title or ownership circumstances.

This is not an exhaustive list. Laura & Cheryl can provide contact information for tax professionals upon request, but the seller should independently evaluate and select the professional.