The Internal Revenue Service considers all property, whether for personal or commercial use, to be an asset. When calculating the gain or loss on a sale, you're determining the difference between the sales price and the basis -- which is rarely the same as the purchase price. How the gain is taxed depends on quite a variety of factors, including the type of property, amount of loss or gain, and how you used it. Property owned more than one year is taxed as a long-term capital gain.
You may be able to exclude up to $250,000 in capital gains on the sale of a personal residence. Any amount not excluded is subject to long-term capital gains tax, currently at 15 percent for most taxpayers. The flip side of the exclusion is that if you sell at a loss, you cannot take a tax break for the amount of loss. To claim the exclusion, you must have lived in your home as a primary residence for two years during the last five years you owned it. The years do not have to be consecutive. You may still qualify for the exclusion if you lived away due to a job in the military, the Foreign Service or the Peace Corps. If you sold another primary residence in the prior two years, you will not qualify.
Example: Jim and Joan have owned their home for six years, and rented it out for 15 of the last 60 months. They lived in the home for the remaining 45 months. They are entitled to take the full exclusion because they lived in the house for at least 24 months during the last 60.
Basis and Adjusted Basis for Residences
For your primary residence, basis is determined by how you got your home. If you bought the home, the basis will be the amount you paid for it. If you inherited the home or received it as a gift, the basis is the fair market value at the time you received it, or the previous owner's adjusted basis. You may add to your basis any closing costs and settlement fees that did not cover property tax or insurance. Also add in the amount of any improvements you paid for while you lived in the home, including a new roof, new floors, landscaping, new plumbing and insulation. Subtract the adjusted basis from the sales price to determine the amount of any capital gain.
Example: Bob and Sue bought their home for $100,000 in 2000. They had closing costs of $1,000, and made improvements of $15,000 for landscaping, new kitchen appliances and insulating the roof. The adjusted basis of their home is $116,000. They sold the home in 2011 for $200,000. Their capital gain is $84,000. They can take the full exclusion and owe no capital gains taxes on the sale.
There is no exclusion of capital gains for residential rental property or commercial property. Your tax break comes in how the adjusted basis is calculated and in the depreciation you claimed in prior years. You may also take a tax break for a capital loss on property sold below its basis. If you held the property for more than one year, you will pay a 15 percent capital gains tax on the gain that is not due to depreciation. You will pay 25 percent on capital gains on amounts previously taken as a depreciation deduction. This is called a 1250 recapture, to pay tax on previously untaxed income on the property.
Calculating Basis and Adjusted Basis for Rentals
Like personal use property, rentals are only taxed on the capital gain. Adjusted basis for rental property is calculated differently. Basis is still the purchase price, or fair market value of property received as inheritance or a gift. You may add in the cost of improvements, remodeling and upgrades. However, if you took depreciation on the property during the time you owned it, you must subtract that amount from the basis. The depreciation was previously excluded from rental income, and now the IRS wants tax back on those amounts.
Example: Rita and Raul own a second home and rent it out. Their adjusted basis is $150,000 and they have accumulated depreciation of $30,000. They sold the property for $250,000. Their total capital gain on the sale is $130,000 ($250,000 – (150,000 adjusted basis – 30,000 depreciation)). However, $30,000 of the gain is recaptured depreciation, which is taxed at 25 percent. The remaining $100,000 of capital gain comes from appreciation in the value of the asset, so it is only taxed at 15 percent.
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