Please note that this blog is based on laws effective in August 2020 and may not contain later amendments. Please contact Cray Kaiser for most recent information.
The rules surrounding the sale of one’s principal residence have changed over the years. It used to be that you could simply rollover your gain on a tax-free basis as long as you reinvested the proceeds into a new principal residence. However, those gain on home sale rules have since been eliminated and replaced with a principal residence exclusion. Here’s how it works:
Individuals who use and own their home as a principal residence for at least 2 out of the last 5 years before sale can exclude a portion of the gain from tax. This rule is regardless of prior sale gains that have been rolled over. Those who meet the 2-out-of-5-year use and ownership tests can exclude up to $250,000 ($500,000 if both filer and spouse qualify) of gain from the sale of their home, and generally don’t need to keep a record of improvements made to the home.
But what happens when you don’t meet the exclusion rules? Here are some situations that could lead to a taxable gain on the sale of your home:
- The home is owned for a long period of time, and the combination of appreciation in value due to inflation and improvements exceeds the exclusion amount.
- The home is converted to a second residence or rental property, and the exclusion might not apply to the sale.
- The home is sold before meeting the 2-year use and ownership requirements.
- The home only qualifies for a reduced exclusion because the home is sold before meeting the 2-year use and ownership requirements.
- One spouse retains the home after a divorce and is only entitled to a $250,000 exclusion instead of the $500,000 exclusion available to married couples.
- There are future tax law changes that could affect the exclusion amounts.
In these cases, it is important to keep home improvement records in order to substantiate a reduced gain. We understand that keeping records can sometimes feel like a burden. But, consider the alternative. For every dollar of improvements that you cannot substantiate, you will recognize a higher capital gain on the sale of your home. As a result, you will be subject to the capital gains tax. Additionally, there is a good chance your overall tax rate will be higher than normal simply because the gain pushed you into a higher tax bracket. Before deciding not to keep records, carefully consider the potential of having a gain in excess of the exclusion amount.
You’re likely wondering which records to keep. We don’t recommend keeping the receipt for every can of paint purchased or ripped screen replaced, as these wouldn’t be eligible as improvements. However, you should file away receipts, invoices, contracts, etc., and cancelled checks, credit card receipts or bank records to prove payments when you make improvements such as adding a room, putting on a new roof, or remodeling the bathroom.
If you have questions related to the gain on home sale rules or questions about how keeping home improvement records might directly affect you, please contact Cray Kaiser today.