Know the Tax Ramifications

Mark and Cheryl Johnson, a hypothetical couple, purchased their 2,000-square-foot home in 1985 for $72,000. They raised two kids and numerous pets in the house, but now they are tired of walking up and down stairs with their laundry. Their kids and grandkids live in another state, so their extra bedrooms are rarely occupied—and caring for the sizeable yard has become more of a burden than a pleasure.

Still, the Johnsons are reluctant to move. Comparable houses in their neighborhood now sell for $650,000 or more. They'd love to tap some of that equity for travel—and to buy a place closer to their kids—but they dread the expenses and hassle associated with selling.

They're especially reluctant to get hit with a big capital gains tax bill. Yes, they know about the $500,000 capital gains exclusion on the sale of a primary residence ($250,000 for single filers), but they anticipate a net gain of nearly $580,000 after selling expenses. In their tax bracket, a sale would trigger nearly $12,000 in federal capital gains tax.

Or would it? The Johnsons say they haven't made as many improvements as their neighbors—and they're not sure how good their records are. But after talking it through with their real estate agent and digging through files, they come up with receipts for some big-ticket items. Early on, for example, they added central air (cost: $14,000). They replaced the roof and siding after a big hailstorm (cost after insurance: $10,000). In anticipation of a family gathering, they borrowed from their retirement funds and spent $20,000 on a stone patio and professional landscaping. And after they paid off their mortgage in 2015, the Johnsons treated themselves to a kitchen remodel (cost: $35,000).

Those improvements, properly documented, bring their tax basis up to $151,000. In addition, they can deduct the cost of selling their home (IRS Publication 523, Selling Your Home).

If their house sells for $650,000 after selling expenses, they'll clear the exclusion limit and face no capital gains tax.

Takeaway: You don't have to be a tax expert to talk with sellers about the potential tax consequences of their sale. Understand the basics—including what constitutes a primary residence, what qualifies as an improvement and what documentation sellers are required to have. Then, be prepared with the names of tax professionals who can help them evaluate their individual situation, as well as links to credible tax guidance online. (The Internal Revenue Service is the authoritative free source of guidance. See "Topic no. 701, Sale of Your Home".)