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Real Estate Sale Financial and Tax Planning

Insights

By J.P. Mayer, MSBA, CFP®

The Case-Shiller U.S. Home index rose 19.7% in July 2021, the fourth consecutive month of record price appreciation.  San Diego posted the second-fastest year-over-year growth rate of all major metropolitan areas, at 27.8%.[1]  The U.S. median existing-home sales price hit a record $362,800 in July 2021[2].

The historically hot housing market has spurred homeowners to consider listing their real estate for sale to take advantage of the current market conditions which asymmetrically favor home sellers.

If you are planning or considering the sale of real estate, you should be aware of tax and financial implications thereof before you list a property for sale.

Tax Considerations of Sale

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Capital Gains Taxes

Calculation of Taxable Gain

If the amount you realize from the sale, less your selling expenses, is more than your adjusted basis in your home, you have realized a capital gain on the sale.

A portion of this gain may be excluded from taxation under a Section 121 exclusion, otherwise known as a ‘primary residence exclusion’. To claim the exclusion, the property must have been your primary residence for 24 months in the past five years before the sale.  The 24 months do not have to be consecutive.

The primary residence exclusion allows tax filers to exclude capital gains up to $250,000 if filing single, and up to $500,000 if married filing jointly.  Any gain you realize over the exclusion amount is taxed at the federal level as a long-term capital gain if you owned the house for more than one year.[3]

Calculation of Adjusted Cost Basis

The first step to determine your taxable gain is to determine your adjusted cost basis.  Your adjusted basis is your cost in acquiring your home (purchase price, closing costs, etc.) plus the cost of any capital improvements you made in the past. 

Deductions from Sale Proceeds

The deductibility of expenses incurred preparing your home for sale can be divided into three categories: 

1) administrative
2) capital improvements
3) repairs and maintenance

Administrative and capital improvement costs are deductible.   Repair and maintenance costs are not.   What distinguishes capital improvement costs from repair and maintenance costs?  According to the IRS, capital improvements “add to the value of your home, prolong its useful life, or adapt it to new uses” while repairs and maintenance costs are “any costs that are necessary to keep your home in good condition but don’t add to its value or prolong its life”.[4]

Exceptions to the Prohibition on Deducting Home Repair Expenses

If You Qualify for the Home Office Deduction

To qualify for the home office deduction, you must have a legitimate business and use part of your home exclusively and regularly for the business.  If you qualify for this deduction, you can deduct 100% of the cost of repairs made to your home office. For example, if you use a bedroom in your home as a home office and pay to replace a broken window with a similar window you may deduct the entire cost.

Repairs that benefit your entire home are deductible according to the percentage of home office use. For example, if you use 20% of your home as an office, you may deduct 20% of the cost to repair your home heating and air conditioning system.

You Rent Out Part of Your Home

As with the home office deduction, improvements that repair only the portion of the home being rented can be deducted in full. Repairs that benefit the entire home can be deducted according to the percentage of rental use of the home.[5]

Sample Calculation of Taxable Gain

  • A married couple purchased a primary residence in 2011 for $600,000 and have lived in it continuously since.
  • Over the years they undertook several renovations costing $100,000 that materially added to the value of the home.
  • In 2021 they sold their home for $2 million, incurring $100,000 in selling fees.

Federal Capital Gains Tax Rates

Your total taxable income determines your long-term capital gain rate.

CA Capital Gains Tax Rates

California does not have a lower rate for capital gains. All capital gains are taxed as ordinary income rates.[6]

Considerations for Replacement Property

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Carryover Property Tax Basis


Prop.19 overview

California’s Prop 19. applies to residents age 55 and older, severely disabled, or a victim of a wildfire or natural disaster.  Effective April 1, 2021, those eligible homeowners can sell their homes and take their property tax base with them to any other property they buy for the same value or less in the state of California.[7]

  • Buy a replacement primary residence anywhere in California within two years of the sale of the original primary residence – either before or after the sale as long as one of the transactions occurs on or after April 1, 2021, and retain the property tax base of the original home so long as the replacement property is valued at $1 million or less.
  • This property tax base transfer can now be moved up to three times in your life anywhere in California.

Prop. 19 Application to Replacement Properties over $1 million

Eligible residents can still benefit from Prop. 19 even if their replacement residence exceeds $1 million.

  • Carryover property tax basis applies up to the amount of the sales price of the original residence.
  • The difference between the sales price of the original residence and the replacement residence will be taxed at the normal property tax rate.

Sample Calculation Carryover Property Tax Basis Under Prop. 19

  • A couple, both over age 55 sell a home purchased for $400,000 many years ago for $800,000.
  • They purchase a new home for $1.5 million.
  • Their new property tax base will be $400,000 on the first $800,000 of value, with the remaining $700,000 difference added to the $400,000 carryover basis.   Effectively this results in a property tax base of $1.1 million on the new home which was purchased for $1.5 million.

[1] https://www.sandiegouniontribune.com/business/real-estate/story/2021-07-27/san-diego-home-prices-now-up-25-in-a-year
[2] https://fred.stlouisfed.org/series/HOSMEDUSM052N
[3] https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc
[4] https://www.irs.gov/pub/irs-pdf/p523.pdf
[5] https://www.irs.gov/pub/irs-pdf/p523.pdf
[6] https://www.ftb.ca.gov/file/personal/income-types/capital-gains-and-losses.html
[7] https://www.boe.ca.gov/prop19/

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