The starting point for avoiding long-term capital gains tax on the profitable sale of your personal residence and investment real estate is its adjusted cost basis. This number is needed because it must be subtracted from the property seller’s “adjusted sales price” to arrive at the long-term capital gain when the property is sold. Most property owners think their adjusted cost basis is their purchase price. As we will see, that is often wrong!
1. The basic “adjusted cost basis” rule. The starting point is usually (a) the property purchase price, plus (b) any purchase expenses that were not tax deductible at the time of purchase.
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EXAMPLE: If you bought your personal residence for $200,000, paid $2,000 in tax-deductible loan fee points to obtain your home acquisition mortgage, and paid $5,000 in various non-deductible closing costs such as transfer fees, attorney or escrow charges, and title fees, your home’s adjusted cost basis is $205,000. The $2,000 mortgage loan fee points qualify as an itemized income tax deduction in the year of home purchase. Each “point” equals 1 percent of the amount borrowed. But the mortgage amount doesn’t matter for determining the adjusted cost basis.
2. Subtract any “rollover” deferred capital gain from principal residence sales before May 7, 1997. If you used the old now-repealed Internal Revenue Code 1034 “rollover residence replacement rule” before May 7, 1997, don’t forget to subtract from your home’s adjusted cost basis, as explained above, the amount of any deferred capital gain from the sale of your prior principal residence(s). You might even have deferred “rollover” capital gains from more than one principal residence sales before new IRC 121 replaced the old rule. The new IRC 121 exemption, discussed below, includes these “rollover deferred capital gains.
3. If real estate was acquired in an Internal Revenue Code 1031 tax-deferred exchange, subtract the amount of the tax-deferred capital gain profit from the acquisition cost. Although your tax adviser will calculate your exact adjusted cost basis for property acquired in an IRC 1031 tax-deferred exchange, such as a rental house or an apartment building, a quick shorthand method to estimate your adjusted cost basis of the acquired property is to use your purchase price and then subtract your deferred capital gain resulting from the old exchanged property.
EXAMPLE: Using an IRC 1031 tax-deferred exchange, suppose you had a $100,000 capital gain on the sale of a rental house, which you traded for a $600,000 warehouse. From your $600,000 warehouse purchase price, subtract the $100,000 deferred capital gain to arrive at a $500,000 estimated adjusted cost basis for the warehouse. Of course, be sure to add any non-deductible acquisition costs to arrive at the warehouse’s full adjusted cost basis.
4. Add the total costs of capital improvements made during property ownership. Most homeowners and property investors fail to keep accurate records of their total capital improvements added during ownership. Be sure to add the cost of capital improvements to your property’s adjusted cost basis. To illustrate, if you paid a contractor to build a new $5,000 deck, or had new landscaping installed for $10,000, those are capital improvement costs to be added to your cost basis. However, if you did the labor yourself, then only the costs of the materials qualify as capital improvements. Your labor is valued by Uncle Sam at zero!
EXAMPLE: If you had a new roof installed on your house for $10,000, add that $10,000 to your home’s adjusted cost basis. However, if you just repaired your leaking roof at a cost of $1,000, that’s a personal expense without any tax significance because repair costs on a personal residence are neither tax deductible nor are they capital improvements. However, repair costs on an investment property are tax-deductible expenses in the tax year paid.
5. Subtract total property depreciation deducted on your income tax returns. If you rented all or part of your real estate during ownership years, you should have deducted depreciation on your income tax returns. To illustrate, if you rented your house to tenants for a year while you were in Europe, you probably deducted depreciation on your Schedule E of your income tax returns for those 12 months. That’s the same place you reported the rental income. Or, if the property was always a rental during your ownership, then you had many years of annual tax-saving depreciation deductions. Add the total depreciation deducted on your tax returns and then subtract the total depreciation from the property’s adjusted cost basis.
Depreciation tax deductions must be subtracted to arrive at your home’s adjusted cost basis. Most investment property owners are very familiar with the depreciation deduction, which is a major tax benefit of owning depreciable real estate, but it also reduces their property’s adjusted cost basis.
HOW TO KNOW YOUR “ADJUSTED SALES PRICE.” After estimating your home or investment property “adjusted cost basis,” if you are thinking of selling that property, it pays to estimate its adjusted sales price. Briefly, that is the gross sales price, minus non-deductible selling expenses such as the real estate sales commission, transfer taxes, and attorney or escrow fee. Such sales expenses aren’t deductible, but they are subtractible from the gross sales price.
Your long-term capital gain is the difference between the adjusted sales price and the adjusted cost basis. This capital gain amount may be eligible for either full or partial tax exemption, or tax deferral, depending on the type of property (principal residence or other property).
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