Last week, I shared information on how to avoid Uncle Sam’s nasty surprises when selling your home, especially when it comes to capital gains tax. Since then, I’ve learned that some people don’t really understand the difference between proceeds and profit, which is key to understanding how you’ll be taxed.
The product is the money that you leave after the sale. They include the selling price minus the amount you owe on the loan minus the costs associated with selling your home.
Capital gains taxes are calculated based on profits rather than products, which is a whole different calculation. Capital gains are defined as the amount by which the proceeds from the sale of a capital asset (in this case, your home) exceed the base. The tax value of your home is called the tax base and its calculation involves several factors. Profit is the sale price minus the allowable costs of selling your home minus your base in the property.
You would think that the tax base would simply be the initial purchase price of a property, but that is not the case. Usually, the tax base is the purchase price plus certain closing costs, such as title insurance. (If you’re dealing with more complex transactions, such as exchanging investment property, things get a bit more complex, but let’s stick to your primary residence for now.)
Once you have your home’s tax base, it can increase if you make certain types of improvements. Improvements are major renovations or changes, such as adding a bedroom or replacing the roof. The line between maintenance or major repairs and improvements can become very blurred.
An increase in your tax base can be beneficial if you plan to sell as a higher base will reduce your capital gains and therefore your capital gains tax (if the capital gains exceed a certain threshold).
Let’s go back for a moment to the boundary between an improvement and a repair. On a personal residence, a new roof is often considered an improvement. On an investment property, it is generally considered a repair. So not only is it sometimes difficult to determine if an update to your home meets the criteria to be considered an improvement, but it’s also important to note that primary residences are treated differently than investment properties.
An IRS auditor once asked me to capitalize the cost of repairing a lateral sewer from an apartment complex to the sewer line on the street. While I felt it was a repair because the lateral was already there (I was just fixing it), the checker insisted it was an improvement capital city. Because it was an investment property, I wanted it to be a repair that I could spend in the year I paid for it rather than having to write it off over the years.
Whether your expense is an improvement or a repair, I strongly recommend that you keep good records. If you’re spending $25,000 on a new roof for your home, you’ll want to be able to prove you spent that money when you sell.
One of the hidden traps in this world is the advice to only keep tax returns for seven years. In fact, you must keep tax records up to the date of acquisition of a given property. Keep ALL tax records so you can prove expenditures against improvements.
If you own investment property and have completed a 1031 exchange, keep records of all properties involved in the full history of the exchange. If you own an investment property, you will need a large filing cabinet or a large hard drive. I recommend paper backups for electronic records. Why? Because there are two types of disk drives: those that have failed and those that will fail.
Before making any financial decisions, be sure to talk to your accountant or financial advisor. I am neither.
If you have any questions about property management or real estate, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery. To view previous articles, visit www.selzerrealty.com and click on “How’s the Market Going”.
Dick Selzer is a real estate broker who has been in the business for over 45 years.
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