When selling a house, understanding the intricacies of determining the taxable gain or loss from the sale of property is very important. This is so ,The difference between the “amount realized” and the “adjusted basis” determines whether you have a capital gains or a loss from your sale. So, let us understand these terms.
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What is the Amount Realized?
The amount realized on the sale of a house is the total consideration you receive from the property buyer. This includes money and the fair market value of any property or services you receive. It’s not just the sale price; you should also factor in any additional amounts you may receive, such as payments for fixtures or improvements.
How do we compute “the amount realized?
- Start with the gross sales of the property.
- Deduct any selling expenses like commissions, advertising, legal fees, and other costs directly tied to the sale of your property.
- Also, subtract any mortgage or other debt on the property the buyer undertakes to repay.
The resulting figure is your “amount realized”.
Example: If you sell your House for $500,000 and pay $20,000 in commission, and the buyer assumes your $50,000 mortgage, your amount realized is:
$500,000 (sale price) – $20,000 (commission) + $50,000 (mortgage) = $530,000.
What is the Adjusted Basis of the Property?
The property’s adjusted basis is its original cost, plus capital improvements and then adjusted for certain other factors like depreciation if claimed earlier. Following is the computation of the “adjusted basis.”
Here’s how you determine the adjusted basis:
- Step 1: Write down the purchase price of the property.
- Step 2: Add capital improvement costs like building a new room, a fence, a roof, or any other permanent improvement that increases the property’s value.
- Step 3: Deduct the amount of depreciation (commonly known as Depreciation Recapture ) on the property, like if claimed earlier.
- Step 4: Other events can adjust the basis, like casualty losses you’ve deducted or credits you’ve received.
Example: If you bought your House for $200,000, spent $50,000 on a new small baby room, and claimed $20,000 in depreciation over the years, your adjusted basis is:
$200,000 (original cost) + $50,000 (improvements) – $20,000 (depreciation) = $230,000.
Seven factors that affect the basis of your property
There are seven situations in which the adjusted basis of your House may change per situation. These are :
Situation 1: Payout or deduction for the flood or disaster?
When you experience a casualty loss due to a disaster, like a flood, hurricane, or fire, and you receive any relief, it can affect the adjusted basis of your property when you sell the disaster-affected property. The following two adjustment is needed :
- If you receive an insurance payment for the damage to your property, you’ll need to subtract this amount from the property’s basis.
- If you don’t receive an insurance payout and instead take a deduction on your tax return for the casualty loss, you must reduce the basis by the deduction amount.
Situation 2: Granted any easement on your property?
If you grant someone an easement (or a right to use a portion of your property in a specific way) and receive compensation, this reduces your basis in the property.
Situation 3: Received energy credits? If you’ve taken any credits for home energy efficiency improvements, you should reduce your basis by the amount of the credit received.
Situation 4: Property received as a Gift?
In the case of property received as a gift, the purchase amount is nil. However, the law allows the recipient to consider the donor’s adjusted basis, with some adjustments for gift tax paid.
Situation 5: if the House was your inherited property, the basis of inherited property is typically its fair market value (FMV) at the date of the decedent’s death or an alternate valuation date.
Situation 6: Was your property part of Section 1031 exchanges?
If you swap one House for another, the basis can carry over, and it will require adjustments based on the fair market values of the properties exchanged and any additional money paid or mortgages taken on.
How to determine capital gain or loss on the sale of the House?
Once you have both the amount realized and the adjusted basis, determining your capital gain or loss is simple:
Gain or Loss = Amount Realized – Adjusted Basis
Using our examples above, the gain from the house sale would be $530,000 (amount realized) – $230,000 (adjusted basis) = $300,000 gain.
How do you decide on tax on the capital gains?
Two more things need your attention. One is whether you are eligible for the exclusion of some amount of income. If you are eligible, you may qualify for capital gains exclusion under section 121 of the Internal Revenue Code up to $250,000 of that gain from your income or up to $500,000 of that gain if you file a joint return with your spouse.
From the above example, your taxable gain will be $50,000 ($300,000- $250,000). Please read the topic.” Capital Gains Exclusion: Eligibility, Limitations on the exclusion amount, and Exceptions “
Lastly, you must know what tax rate will apply to the net gains. To determine the tax on the gains, you need to categorize the gains or losses in Long Term Capital Gains or Short Term Capital Gains. In simple terms, any sale of a house, held for 12 months or more before the sale or transfer, is a long-term capital gain, and the tax rate specified for long-term capital gains shall apply. For this purpose, you need to count the House’s holding period. You can read more about it: “How to determine the period of holding of the property?”
Why keeping records is essential!
While these calculations might seem straightforward, the devil is often in the details, especially with the myriad of adjustments that can impact the adjusted basis. Always maintain a meticulous record of all property-related transactions, improvements, and deductions to ensure accuracy when determining your gain or loss on a sale.
While the information on this site - Internal Revenue Code Simplified-is about legal issues, it is not legal advice or legal representation. Because of the rapidly changing nature of the law and our reliance upon outside sources, we make no warranty or guarantee of the accuracy or reliability of information contained herein.