When it comes to being better? What’s better, paying taxes or not paying taxes? I think we can all agree, not paying taxes is better! It reminds me of this cute AT&T commercial “Better”

No one wants to pay more taxes than they are required to pay. So when you are looking to buy and sell real estate in California, one concept that is important to understand is the capital gains tax. Knowing if your gains are fully, or partially, excluded from being taxed could make a big difference on your tax return and your bottom line. Will you get a refund or will you have to write a check? You’ll want to learn the rules for what qualifies and how you can claim any applicable exclusions. This blog reviews the high-level basics so that you and your tax advisor can best work together to minimize the tax on any gain. Your gain, and thus your taxable amount might be lower than you think.

What are Capital Gains?

When you make a profit in real estate, it is known as a capital gain. For many people, one of the biggest assets they have is their home, and, in hot real estate markets like the Bay Area, a homeowner has the potential to realize a huge capital gain on a sale. Fortunately, for homeowners, federal tax law allows you to exclude some, or all, of that gain from the sale of your primary residence from capital gains tax.

This relief from some capital gains is mandated by Code Section 121,   “Exclusion of gain from sale of principal residence” , which allows a taxpayer to exclude gains from gross income up to:

$250,000 or

$500,000 for married filing joint

The exclusion may be applied as long as you meet the following three conditions:

• Ownership:  You owned the home for a minimum of two years  before the sale;  **For married filing joint couples, the ownership test is satisfied if either spouse meets the ownership requirement.
• Use:  You lived in the home as your primary residence for a total of two years in aggregate in the 5-year period ending on the date of sale; **for married filing joint, both taxpayer and spouse must meet use requirement and
• One Sale in Two Years: You haven’t claimed the exclusion on another property in the last two-year period ending on the date of the current sale.

Taxpayers who do not meet these tests for the full gain exclusion to apply may still be eligible to exclude part of the gain under the partial gain exclusion rules.  The partial gain exclusion rules are beyond the scope of this blog post, but certainly should be taken into consideration and discussed with a tax professional if you find yourself in this position.

Investment properties

Different rules apply for capital gains on your primary residence versus an investment property. In this blog, I’ll only discuss the rules that apply to primary residences. There are ways, such as a 1031 exchange to defer capital gains tax on investment properties. Do your research and consult a tax adviser or 1031 exchange specialist.

How Much Is Your Gain?

Your capital gain is your selling price (minus closing and selling costs) minus your adjusted cost basis. Many people incorrectly believe that their gain is simply the difference in original purchase and final sale price. For example, if you buy your house for $500K in 2002 and sell it for $1.5M in 2018. Is your gain $1M? Not necessarily.

Calculating your Cost Basis

You can calculate your adjusted cost basis by adding the original purchase price + purchase expenses + capital improvements – any depreciation claimed (if you had a home office you may have claimed depreciation for the business use portion). For example, on that $500K purchase price, you can add:

Purchase expenses

• Settlement and closing costs, including the fees and transfer taxes paid to acquire the property whether they are paid in cash, in trade or through a loan.
• Fees include real estate brokerage fees or commissions, legal fees, recording fees, title & escrow fees, accounting fees, installation and testing fees, transfer and sales fees.
• Taxes include sales tax, excise tax, revenue stamps, transfer tax, etc.

Capital improvements

A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property’s overall value, increase its useful life or adapt it to new uses. Some examples of these include:

• Adding a room (bathroom, bedroom, game room)
• Remodeling or updating a kitchen, new cabinets, appliances (that will remain at the home upon sale), fixtures, counter tops, flooring
• Adding a patio, deck or garage
• Basement finishing
• Installing new HVAC, plumbing, wiring, roof

• New landscaping, sprinkler system, and fences
• Installing new flooring or carpet
• Paving or expanding the home’s driveway

Capital improvement vs. Repair?

The IRS makes a distinction between capital improvements and repairs, which cannot be included in a property’s cost basis. A capital improvement increases your home’s value and has a useful life of more than one year, while a repair maintains or returns something to its original condition. Routine upkeep does not increase your basis.

As a helpful hint, here are some ways to determine if an expense should properly be labeled a repair:

• Expenses that “keep” the property in efficient operating condition
• Protecting the underlying property through routine maintenance
• Are incidental to the property

For example, fixing a broken window after your kid threw a baseball at it, is a repair and would not be a capital improvement.  However, replacing old windows throughout the home with new energy efficient windows is a capital improvement, even if you replace one window at a time over a period of time.  Repair expenses such as replacing one window at a time, as part of a general plan of rehabilitation, modernization, and improvement add to the basis of the home.

Keeping track of capital improvements

You need to have records (receipts and credit card or bank statements) to support your home’s adjusted basis. Most people can remember what they paid for their house, but not necessarily how much money they spent on improvements over the life of ownership. Even if you do have receipts, do you know where to find them all? Are they tucked away in a shoe box, under the mattress or in a file drawer somewhere? It can be time-consuming to add up all of the improvements that have been made over the course of years or decades.  This task can be very tedious for sure, but it can pay off big come tax time. Just remember, there is a difference between improvements and repairs. Improvements can be included in the adjusted cost basis, but repairs cannot.  A good idea is to retain documentation for significant expenditures you make throughout the life of ownership of the home.  Go through your list of expenditures with your tax adviser for specific guidance on what does and does not add to the home’s adjusted basis when it is time to sell.

Tax rules are complex and professional guidance is highly recommended to take full advantage of these benefits. This blog reviews the high-level basics so that you and your tax advisor can best work together to minimize the tax on any gain.

The above posting is for informational and intellectual use only. The above information does not constitute financial or legal advice.

The laws and interpretations of them are constantly changing so the information contained herein may not always be definite, complete or current. You should not act or forgo action on the basis of information contained in the above blog post.  You should always seek, obtain and consider specific financial and legal advice with respect to your matters.