The Internal Revenue Service requires taxpayers to include on a tax return the amount of gain resulting from the sale of a home. However, the rules governing the sale of a home used by the taxpayer as a main residence provides potential tax benefits to sellers. Taxpayers who want to take advantage of the benefit must ensure strict compliance with all reporting requirements.
Taxpayers must calculate the cost basis of a purchased home before determining the amount of taxes owed. The cost basis of a house will include other costs in addition to the actual price paid. Basis also includes the amount of real estate taxes paid on behalf of a former owner if not part of the purchase price. Settlement costs such as legal fees, recording fees, surveys and title insurance are also included in the home's tax basis.
Taxpayers who have a home built can include all costs of construction in the home's tax basis. This includes the price paid for land, labor, materials, architects, contractors, building permits, inspections, and fees to rent equipment. The tax basis of the home will increase by other amounts expended for long-term improvements. This includes building additions to the house, installing a pool or constructing an outdoor deck. It will not include expenses paid for necessary maintenance and repairs that do not add value to the property.
Determining the amount of gain from the sale of a home is calculated by subtracting the tax basis of the home immediately preceding the sale from the sales price. In addition to money received from the buyer, the sales price also includes the amount of debt assumed by the buyer plus the fair market value of other property or services provided as part of the sale. The resulting gain is further reduced by an amount equal to selling expenses you incur. These include commissions, advertising and legal fees, and loan placement fees or points.
A taxpayer's personal residence is a capital asset. Gains derived from the sale of a capital asset are subject to capital gain rates of taxation. The amount of tax owed on a gain will vary depending on a particular taxpayer's situation. However, capital gain rates are lower than the tax rates imposed on ordinary income, such as employment wages and interest.
Exclusion of Gain
If the capital gain is related to the sale of a taxpayer's main personal residence, up to $250,000 of the gain can be excluded from taxation. To qualify, you must have owned the home and lived in it for two years within the five-year period immediately preceding the date of sale. An additional requirement is that you did not exclude gain from another home sale in the two-year period prior to the current sale. Married couples who file a joint return may qualify for an increased exclusion of $500,000 if both taxpayers separately meet all requirements.