When selling your home you may be responsible for paying capital gains taxes, which are defined as taxes paid on the positive difference between the sale price of your home and the original purchase price. To understand how much you will owe you will need to know what the adjusted basis on your home is. However, unless you have been involved in multiple real estate transactions, you may be unaware of what this means. Therefore, in this article, we are going to take a deeper look into the definition of adjusted basis and the types of costs that can impact this number.
Adjusted Basis Defined
Basis, in simple terms, is defined as the amount that your property is worth for tax purposes. When you first purchase a home, the basis of the home, also known as the cost basis or starting basis, represents the amount you initially paid for the home including certain settlement or closing costs. If you build (or contract to build) a new home, your starting basis will be equal to the total costs of construction which can include materials, equipment, and labor. However, if you inherit a home, the starting basis is equal to the fair market value (FMV) of the property on the date of the previous owners death.
Still, this amount can change over time, depending on a few factors that influence the value of the home – When this occurs, the revised value of the home becomes recognized as the adjusted basis. In other words, the adjusted basis refers to how much you lose or gain when you sell a property.
Costs Included in Adjusted Basis
There are several factors that can influence your adjusted basis and can result in either an increase or decrease to the starting basis. Here are a few common examples:
Increases to Basis
- Capital improvements.
- These refer to improvements that have a usefulness for more than one year, but exclude expenses incurred due to incidental repairs and maintenance. Examples include: additions to the home, replacing the roof, installing a new deck or fencing, paving a driveway, plumbing or wiring upgrades, kitchen upgrades, installing central air conditioning, to name a few. It’s important to remember that these improvements can only be considered if they are still part of the home during the assessment.
- Assessment for local improvements.
- These include projects that benefit your neighborhood and can include paving roads, installing sidewalks, bike paths, sound barriers, or improvements to utility connections.
- Casualty Losses.
- This refers to the amount paid to restore a property after it is destroyed by events such as theft, fire, flood, storm, or any other casualty.
- The cost of extending utility service lines to the property.
- Impact fees.
- Legal fees, such as the cost of defending and perfecting title.
- Legal fees for obtaining a decrease in an assessment levied against your property to pay for local improvements.
- Zoning costs.
Decreases to Basis
- You can decrease the basis of your property by the depreciation you deducted, which should be calculated annually. Your home depreciates over 27.5 years (determined by the IRS), or at a rate of 3.636% per year.
- Canceled Debt
- You can exclude canceled debt from income in the following situations: (1) Debt canceled in a bankruptcy case or when you’re insolvent, (2) qualified farm debt, and (3) qualified real property business debt (no C corps).
- Deferred capital gains from prior 1031 exchange(s).
- Section 179 deduction.
- Nontaxable corporate distributions.
- Deductions previously allowed (or allowable) for amortization and depletion.
- Exclusion of subsidies for energy conservation measures.
- Residential energy credits.
- Investment credit (part or all) taken.
- Casualty and theft losses and insurance reimbursement.
- Rebates treated as adjustments to the sales price.
Now, let’s look at some examples.
If you purchased your home for $1,000,000, incurred $10,000 in closing costs, and made $60,000 in capital improvements and claimed $200,000 of depreciation, then your adjusted basis would be equal to $870,000.
$1,000,000 + $10,000 + $60,000 – $200,000 = $870,000.
Let’s say you acquire a lot for $200,000 and then build a home for $50,000. You depreciate the home at $9,090 per year. After three years, your adjusted basis would equal $222,730.
$200,000 + $50,000 – ($9,090 x 3) = $222,730.
You purchase a home in 2000 for $1,500,000 and then you paid another $30,000 in various acquisition expenses. Over the years, you incurred the following expenses: $500 for a new water heater, $15,000 for a renovated bathroom, $20,000 in home repairs, $40,000 on a renovated kitchen, and $5,000 for new central air.
- Your starting basis would equal $1,580,000 (home price plus acquisition costs).
- You would increase your basis with your expenses, excluding your expense on home repairs (maintenance and repairs are not considered). This means that your basis would increase by $60,500.
Now, let’s say you sell your home after five years of ownership. At the dedicated depreciation rate, you would deduct $54,540 annually, or a total of $272,700.
Your adjusted basis would then equal $1,367,800.
$1,580,000 + 60,500 – $272,700 = $1,367,800.
It is important to note that these are oversimplified examples to display the concept.
Why is Understanding the Adjusted Basis Important?
When you are ready to sell your home, the difference between your sale price and your adjusted basis is your taxable profit, also known as capital gain. The larger capital gain, the more taxes that you will owe. Furthermore, the amount that you may owe may be a deciding factor as to whether a move is a smart financial decision.
One caveat to note is that there is an exception that removes the necessity for a homeowner to pay capital gains taxes: Based on the Taxpayer Relief Act of 1997, if you are single, you will pay no capital gains tax on the first $250,000 of profit when you sell your home, and if you are married, as couple you are exempt from paying capital gains on the first $500,000 of profit.
If you are interested in learning more about your current position, it is recommended that you consult with a tax professional.