What to Know About Capital Gains Tax

A little studying up on capital gains tax can mean more money in your pocket at the end of the day.
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By: Tara-Nicholle Nelson

Capital gains tax is a tax on the profits you receive when you sell something (like a home) for more than you paid for it. One of the primary benefits of homeownership is its wealth-building potential. Even in a down market, the majority of homes in America are still worth more than their owners paid for them. As such, the majority of Americans will face a potential capital gains issue at the time they decide to sell their home. Fortunately, there are a number of exclusions that allow homeowners to realize a fairly sizeable tax-free profit, or gain, on their main home.

A capital gains issue is a high-class problem to have, in that it only applies when you sell your home at a profit. However, calculating capital gains is a little more complicated with homes than with other types of property. With real estate, your gains are calculated on the amount you get when you sell your home minus your cost basis in the home.

(Your sale price) - (Your cost basis) = Your capital gain

Your cost basis is the price you paid for the home plus the amount of money you have invested in repairs, maintenance and upgrades during the time you owned the property, plus the costs of sale (e.g., commissions, settlement fees, etc.) on both the purchase and sale of the home.

Your purchase price + costs of improving property + closing costs when you bought + closing costs when you sell = Your cost basis

Again, the difference between your cost basis and what you sell the home for is your capital gain.

Before you decide that you will never be able to move into a new home, be aware that capital gains tax policy was designed to avoid making people feel trapped in their homes. When you are selling your primary residence, you are able to exclude $250,000 of gains from your taxable income if you are single, or $500,000 for married couples who file a joint return. In order to take advantage of the exclusion, you must have lived in the property as your main home for at least two of the last five years, unless you had to sell your home because of certain health, job relocation or various other unforeseen circumstances approved by the IRS. Some of the IRS-approved unforeseen circumstances which may justify a full exclusion on an early sale include:

  • Death
  • Divorce or legal separation
  • Unemployment
  • Multiple births from a single pregnancy
  • Natural disaster, war or terrorism resulting in damage to the house
  • Condemnation or governmental seizure of the home

If you have to sell early, and don’t qualify under any of the above “safe harbors” for unforeseen circumstances, you may be able to take a prorated exclusion based on how long the home actually was your main residence. Check with your tax pro. Struggling homeowners take note -- foreclosures are considered property sales for tax purposes, but there are numerous considerations involved in calculating the gain or loss when a home is lost to foreclosure. Talk with your tax professional to determine whether any tax is due on the cancellation or forgiveness of your mortgage debt through a short sale or foreclosure.

NOTE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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