October, 2006 Tax Newsletter

How to Determine the Cost Basis of Your Home

When you sell your home or, for that matter, any other asset, your adjusted cost basis is subtracted from your selling price to determine your gain or loss (usually capital gain or loss).

Basis starts with what you pay for the asset, plus escrow and settlement cost in connection with acquiring it.  Many things can increase or decrease it.  For example, capital improvements are added to basis, but repairs and maintenance are not (see below).

Homeowners can exclude $250,000 ($500,000 on a joint return) of capital gain from the sale of their primary residence provided they have owned and lived in the house for at least two of the previous five years ending on the date of sale.  Gain exceeding those amounts is taxed at capital gain rates which, in most cases, is 15%.  Therefore, you can see that the more items you can add to basis, the smaller the gain (and tax).

Capital improvements are essentially additions and other improvements that add to the value of your home, prolong its useful life, or adapt it to a new use.  Examples include adding a room, finishing a basement, enclosing a carport, paving a driveway, adding a new roof, or putting in new plumbing or wiring.  When an item is replaced, you must remove it from your cost basis.  For example, if you put in new carpeting the replaced carpeting must be removed from basis.  IRS Publication 523 lists many of the items that can be added to cost basis.

Conversely, repairs that merely maintain your home in good condition but do not add to its value or prolong its life cannot be added to basis.  These would include such things as repainting, patching holes in walls, fixing a leaky roof, and replacing a broken window pane.  Admittedly, some items can be close calls as to whether they are improvements or repairs.  One thing is clear, however.  It is incumbent upon the taxpayer to keep records that document any expense that is added to cost basis.

When you sell the home you can deduct from the selling price sales expenses, including commissions, advertising and legal fees, escrow costs, and loan fees and points if paid on behalf of the buyer.  Under prior law, “fix-up” expenses, such as adding a coat of paint or repairing a broken step, could be deducted from the selling price.  That is no longer the case.

If you own residential rental property, the cost plus improvements must be capitalized and depreciated over 27½ years (39 years if commercial property).  Repairs, on the other hand, are fully deductible in the year of the expense.  Again, it is important to maintain records of the costs of the property, improvements, and expenses.

Suppose you sell your principal residence to take advantage of the $250,000/500,000 exclusion and then buy another residence so that you can take advantage of the exclusion again after two or more years.  This works well, except for a possible property tax issue.  If you live in California and have a low property tax by reason of Proposition 13, you can find yourself facing a steep increase in property tax if you buy a new residence of equal or greater value.  The statewide tax rate is 1% of assessed value which, on a new home, would be your purchase price.  That amount could be much higher than what you were paying on the former residence.  There are some exceptions to this which allow a person (or spouse) 55 or older to transfer the former home’s assessed value to the new home if certain conditions are satisfied.