When you sell your home, the Internal Revenue Service isn't likely to be high on your list of things to worry about. However, you might have to share the proceeds from selling your home with Uncle Sam. Knowing the formula for calculating your capital gain on the sale as well as the primary residence exclusion helps you budget for taxes.
The first step to figuring your capital gain on the sale of your home is determining your adjusted basis, or the amount you've paid for the home. Your adjusted basis includes the amount you paid to purchase it as well as the cost of any home improvements (but not repairs) you've made. For example, if you paid $600,000 to buy the home and you spent another $15,000 to pay to redesign the kitchen, your adjusted basis is $615,000.
You also have to calculate your net proceeds from the sale. Thankfully, the IRS doesn't credit you with receiving the entire sale price. Instead, you get to subtract selling expenses, like advertising, commissions and legal costs from the amount you received. For example, if you sold the house for $930,000 but paid the real estate agent $20,000 and paid $5,000 in legal fees, your net proceeds are only $905,000.
Primary Residence Exclusion
If the home you're selling is your primary residence, you may qualify to exclude all or a portion of your capital gain from your taxable income. The maximum exclusion is $250,000 for a person filing as single, or $500,000 in most cases if you are married and filing jointly. To qualify, you must have owned the home for at least two of the past five years and used it as your primary residence for at least two of the past five years. Also, you can't have used the exclusion within the past two years. Married taxpayers qualify if they file a joint return, both spouses meet the use test, one meets the ownership test and neither has used the exclusion within the past two years.
Capital Gain Formula
The formula for calculating your capital gain is your gross proceeds minus your adjusted basis minus any primary residence exclusion for which you qualify. Using the numbers in this example, subtract the adjusted basis of $615,000 from the net proceeds of $905,000 to find your capital gain on the house is $290,000. Then, assuming you qualify for a $250,000 exclusion, you can reduce your taxable capital gain down to just $40,000.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."