Understanding Real Estate Capital Gains on Home Sales

    When you sell a stock or most any asset, you owe taxes on your "capital gain" - the difference between what you paid for the asset and what you sold it for. The same is true with selling a home (or a second home), except that there are some special considerations that benefit you when the asset you are selling is your home.

    Homeowners already know the many tax breaks that Uncle Sam offers, most notably mortgage interest and property tax deductions. But there is even more good tax news for home sellers. Manu home sellers won't owe the Internal Revenue Service any taxes at all on the profit they make on a home sale.

    First, on real estate sales, capital gains are based not on what you paid for the home, but on its adjusted cost basis.

To calculate the capital gain on the sale of real estate:

To the purchase price you paid for the property, add:

• Cost of the purchase-including transfer fees, attorney fees, inspections, but not points you paid on your mortgage.
• Cost of sale-including inspections, attorney's fee, real estate commission, and money you spent to fix up your home just prior to sale.
• Cost of improvements-including room additions, deck, etc. Note that such improvements do not include repairing or replacing items that were in the home when you bought it, such as replacing a water heater or putting on a new roof. These are "maintenance items," not "improvements."

The total of this addition is the "adjusted cost basis" of your home.

    Now, subtract this "adjusted cost basis" from the amount you sell your home for. This is your "capital gain" on the sale.

    Second, and this is where the sale of real estate becomes different from most other asset sales, there's a Special Exemption for Certain Real Estate Capital Gains

    Since 1997, up to $250,000 in such capital gains ($500,000 for married couples) on the sale of a home is exempt from taxation if you meet the following criteria:

• You have lived in the home as your principal residence for at least 2 out of the last 5 years.
• You have not sold or exchanged another home during the 2 years preceding this sale.

    Note that the property you're selling must be your principal residence. That means you have lived in it for at least 2 out of the last 5 years. This tax break doesn't apply to a property that you've owned for investment purposes, such as a piece of rental property. In that case, the usual capital gains rules apply.

    But, if you have the time, you can turn an investment or rental property into your "principal residence" making it eligible for the exclusion. You must move into and live in the home as your "principal residence" for two years meeting the requirement that it be your "primary residence for at least two of the five years before the sale.

    As of 2003, if you do not meet these requirements, you may still qualify for this capital gains rule exemption if you meet certain "unforeseen circumstances" defined by the Internal Revenue Service (IRS), such as job loss, divorce, or a family medical emergency.

    Another bonus of the new IRS rules is that you don't have to buy another home with your sale proceeds. You can use the money to travel to Europe in style, buy an RV and drive across the country or get all those personal things you couldn't afford before. Even better, there's no limit on the number of times you can use the home-sale exemption. In most cases, you can make tax-free profits of $250,000 (or $500,000 if you're married) every time you sell a home.

    Tax laws and IRS rulings are always subject to change and interpretation. So, as with any legal or financial transaction, you are advised to consult a competent real estate attorney and your tax accountant for further information concerning this type of transaction.