A Guide to Capital Gains Tax

Do home improvements reduce tax on capital gains?

You can reduce the amount of capital gains subject to capital gains tax by the cost of home improvements you've made. You can add the amount of money you spent on any home improvements—such as replacing the roof, building a deck, replacing the flooring, or finishing a basement—to the initial price of your home to give you the adjusted cost basis. The higher your adjusted cost basis, the lower your capital gain when you sell the home.

For example: if you purchased your home for $200,000 in 1990 and sold it for $550,000, but over the past three decades have spent $100,000 on home improvements. That $100,000 would be subtracted from the sales price of your home this year. Instead of owing capital gains taxes on the $350,000 profit from the sale, you would owe taxes on $250,000. In that case, you'd meet the requirements for a capital gains tax exclusion and owe nothing.

Take-home lesson: Make sure to save receipts of any renovations, since they can help reduce your taxable income when you sell your home. However, keep in mind that these must be home improvements. You can't take a deduction from income for ordinary repairs and maintenance on your house.

How the tax on capital gains works for inherited homes

What if you're selling a home you've inherited from family members who've died? The IRS also gives a "free step-up in basis" when you inherit a family house. But what does that mean?

Let's say Mom and Dad bought the family home years ago for $100,000, and it's worth $1 million when it's left to you. When you sell, your purchase price (or "basis") is not the $100,000 your folks paid, but instead the $1 million it's worth on the last parent's date of death.

You pay capital gains tax only on the difference between what you sell the house for, and the amount it was worth when your last parent died.

What if I have a loss from selling real estate?

If you sell your personal residence for less money than you paid for it, you can't take a deduction for the capital loss. It's considered to be a personal loss, and a capital loss from the sale of your residence does not reduce your income subject to tax.

If you sell other real estate at a loss, however, you can take a tax loss on your income tax return. The amount of loss you can use to offset other taxable income in one year may be limited.

How to avoid capital gains tax as a real estate investor

If the home you're selling is not your primary residence but rather an investment property you've flipped or rented out, avoiding capital gains tax is a bit more complicated. But it's still possible. The best way to avoid a capital gains tax if you're an investor is by swapping "like-kind" properties with a 1031 exchange. This allows you to sell your property and buy another one without recognizing any potential gain in the tax year of sale.

“In essence, you're swapping one investment asset for another,” says Re/Max Advantage Plus' White. He cautions, however, that there are very strict rules regarding timelines and guidelines with this transaction, so be sure to check them with an accountant.

If you’re opting out of the rental property investment business and putting your money in another venture that does not qualify for the 1031 exchange, then you’ll owe the capital gains tax on the profit.

Resource: www.realtor.com