Sale of A Principal Residence

Buying and selling homes can be an arduous process. You must make sure the home is in top condition and the renovations you plan to make are complete to attract interested buyers at the desired price point. Simultaneously, you may be in the market for a new home which requires research, timing, financial preparedness, and possibly, a bit of luck! However, one of the last things most people think about is the taxable event that could occur from the sale of the house.

how to calculate the sale of a property

For a simplistic example, let’s say you purchased your primary residence back in 2005 for $350,000. This number is considered your original cost basis in the property. You renovated the bathrooms, the kitchen and made sure the entire house was painted from top to bottom. That cost you an additional $60,000 which you are able to add to your original cost basis. Your agent advises you that between your renovations and the appreciation of the home, you can list your home for $650,000. You take your agent’s advice, list the home competitively, and after a bidding war, your house sells for $675,000. You would have a gain on your former home of $265,000 which is the sales price of $675,000 less the adjusted basis of $410,000 (original basis of $350,000 plus the $60,000 of renovations). Conversely, if your home sold for less than the adjusted cost basis, you would have to report a loss. Like other personal transactions, a loss on a principal residence is not deductible.

Alex, we had a mortgage on the house at the time of sale of $100,000?! Shouldn’t we have $100,000 less of gain? The answer is “no”. This is because loans do not affect the gain or loss on the transaction of a house. They do, however, dictate how much cash you will have leftover after the transaction. So, in the case above, your cash proceeds will be $675,000 less the outstanding mortgage of $100,000, or $575,000. This is how much cash you can put in the bank or toward your next property. This is before any taxes due on the gain calculated at the time of sale. However, do not be afraid as there exists assistance for most taxpayers.

principal residence gain exclusion

You might have heard this concept the IRS has put in place that allows for a significant

exclusion of gain on the sale of a principal residence. For those inclined to look at the

tax code, we are talking about Internal Revenue Code section 121. The IRS allows a

$250,000 (single) or a $500,000 (married filing jointly) gain exclusion if, during the five-

year period ending on the date of sale, such property has been owned and used by the

taxpayer as their principal residence for 2 years. These years do not need to be

consecutive. So, using our example above, the $265,000 gain would be reduced to

$15,000 for a single taxpayer would be eliminated altogether for a married filing jointly

taxpayer. Note: This code only pertains to a primary or principal residence. This does

not apply to rentals or vacation homes which are considered investment properties.

conclusion

Even though we seem to be in a period of ever-increasing home prices, this exclusion of

gain on the sale of a principal residence was put in place to help taxpayers keep more

of the equity built up in their homes regardless of economy. However, if you look to take

advantage of rapid appreciation and sell your home prior to the 2-year requirement, be

ready to pay taxes on reported gain.