When you sell capital assets that you own for more than one year, such as your home, the profit you earn on the sale is subject to long-term capital gains tax. The amount of tax you must pay depends on how much you pay for the home and the way in which you use it. When you sell your main residence, you may be eligible to exclude a substantial part of the gain from tax.
The amount of tax you must pay when you sell your home depends on the home's tax basis, which is equal to the amount you purchase it for, some of the settlement costs you incur at closing and the cost of permanent improvements you make. Essentially, this represents your total cost, and any amount you receive beyond this amount is considered your taxable profit.
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Most homeowners will continue to invest in their home by making permanent home improvements to it. These are generally home projects that once completed, increase the useful life and value of the home. Since no tax deduction is available for these costs, the Internal Revenue Service allows you to increase the tax basis of the home. This means that for every dollar you spend on improvements, you are essentially reducing the amount of taxable gain you may recognize on the sale.
Sale of Home
To understand how this works, assume you purchase the home for $200,000 and before you resell it, you make $25,000 in home improvements that include expanding the size of your driveway and turning your basement into an additional bedroom. When you first purchase the home, your tax basis is $200,000; however, when you make those improvements, the basis increases to $225,000. If you sell the home for $300,000 the amount of long-term capital gain that you may be responsible for paying tax on is $75,000. Had you not made those improvements, you would be subject to $100,000 in long-term capital gains.
Excluding Taxable Gain
The federal tax laws provide homeowners with a substantial tax-saving exclusion when they sell their home. Every single taxpayer is eligible to exclude up to $250,000 ($500,000 for married couples) of capital gains on the sale of their main home. To qualify for this exclusion, you must live and own your home for a total of two of the last five years. These two years need not be consecutive, so if you move back and forth throughout the five-year period, you can combine separate periods of residence. However, even if you meet these requirements, you cannot exclude the gain if you've excluded the gain on another home in the last two years. Since this exclusion only applies to your main home, you cannot exclude any gain on second homes such as your vacation properties.