Case Study: Calculating Basis in a Property

Real Estate

The US Census Bureau recently reported that as of the fourth quarter of 2018 the United States homeownership rate is 64.8%. Owning a home – white picket fence or not – continues to be a popular investment as a part of the “American Dream.” Of course, owning a home usually means eventually selling a home. Regardless of whether an upgrade, downside or cashing out, selling a home means determining the slice of the (American pie) capital gain to give the IRS at tax time.

The recipe: net sales proceeds (sale price minus selling expenses) from the home minus adjusted cost basis yields the gain or loss. Adjusted basis is typically the initial purchase price of the home plus closing costs and any improvements made to the property. A loss on the sale of a residence is a nondeductible personal expense with no impact to income taxes. A gain is taxed at capital gain rates.

Internal Revenue Code section 121 provides for some exclusion of gain from the sale of a principal residence. This provides that if a taxpayer lived in the property as a principal residence for at least two of the five years prior to the sale, the taxpayer can exclude up to $500,000 of the capital gain from taxable income for a joint return or $250,000 for single filers. This provision can be used only once in a two-year period.

Sounds simple, right?

For fairly straightforward situations, it can be. The taxpayer may not even need to delve into the full calculation if, for example, there was a married couple that purchased their primary residence for $300,000 in 2005 and then sold it for $425,000 in 2015. There would be no capital gains tax on the sale of the property. They would be able to exclude up to $500,000 of gain, and the simple math is a $125,000 gain.

Following the rules more specifically, the gain is likely even smaller as the gain would be determined at the net sales price minus the adjusted basis of the home sold. For the example above, it would be the $300,000 cost of the home plus any expenses incurred upon the purchase, plus any capital improvements, subtracted from the sale price of $425,000 minus any closing costs and selling expenses.

However, owning a home is akin to putting down roots… and roots tend to get tangled!

Recently, a widowed client whose husband passed away in 2006 was selling her home of 40 years for $500,000 and needed to determine the basis. She was worried about her taxes, as she recalled purchasing her home for around $40,000. Fortunately, that did not end up being her basis in the property.

The widow and her husband purchased their first home nearly 50 years prior. They took advantage of a former law that existed prior to 1997 – the Home-Sale Gain Exclusion Rule – a rollover tax deferral that allowed homeowners to avoid paying tax on any gain on a home as long as they purchased their next home at equal or greater value within two years of the sale of the original home. The intent of this was that any gain on the sale of a primary residence would be deferred, and rolled into the basis of the next home.

The original house was purchased in 1970 for $20,000, which would be their basis in the property at the time of purchase. As their family grew, they looked to purchase their “forever home” in 1978.

The IRS indicates that basis is increased for the actual cost of any improvement that “materially adds to the value of a home, considerably prolongs its useful life, or adapts it to new uses.” These include replacing the roof, rewiring the home, adding an addition, installing central air, or paving the driveway.

Adding $2,000 of capital improvements, their basis in the property at the time of sale would be $22,000.

In 1978, the couple sold the original home for $33,000, with $1,000 in selling costs. The gain on the sale of the property would be $10,000.

Therefore, when the couple rolled over the profits into their new home that they purchased in 1978 for $40,000, their basis in the home would be $30,000, as shown:

Based on the rollover rules, the basis in the new property was to be reduced by any unrecognized gain on the sale of the old property. This means that while the widow recalled purchasing her current home for about $40,000, the basis at the time was actually $30,000 due to the $10,000 deferred gain.

The next piece to untangle was accounting for the widow’s husband’s share of the home, who passed away 12 years prior. When he passed away, she received a step-up in basis for his 50% share of the house. This means her basis would now be composed of 50% of the adjusted basis at the time of his death and 50% of the value of the home at the date of his death, which was in 2006 at the peak of the housing bubble.

Various improvements took place between 1978 and 2006 totaling $50,000.  The adjusted basis at the time of his death would then have been $80,000. Half of that figure will make up a portion of the widow’s basis.

The other portion of the widow’s basis would be the determined by the value of the house at the date of her husband’s death. However, no official valuation took place at the date of his death to determine the exact valuation of the house as it was jointly owned inherited property. In order to create the estimate, in lieu of a valuation, a licensed real estate agent familiar with the market region was asked to supply a letter giving an approximate valuation. The approximate value in 2006 was estimated at $400,000.

At this point, the widow’s basis is 50% of the $400,000 valuation plus 50% of the $80,000, making the basis $240,000. Between 2006 and 2018, she did several more capital improvements to the property which totaled $40,000.

Selling the home for $550,000 in 2018, the widow would be eligible for the $250,000 exclusion since she lived in the home for at least 2 of the prior 5 years. Additionally, with $30,000 attributed to selling costs, her gain on the sale of the home ended up at $240,000 and she was exempt from any capital gains tax on the sale of her home.

Franklin D Roosevelt once said, “Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full and managed with reasonable care, it is about the safest investment in the world.” Notice he said safe – not uncomplicated. For help with the tax rules or determining the basis of a home, reach out to any member of the Withum Real Estate Services Team.

Author: Karen Koch Reilly, CPA, Real Estate Services Group Team Member  |  [email protected]

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