Understanding cost basis: A numbers game
Q: I have a question about selling one’s home and trying to determine the cost basis for tax purposes. Is the profit the difference between the sale price of the house today compared with the current mortgage balance? Or is it the difference between the sale price today and the original purchase price?
A: Let’s make one thing really clear: Your mortgage (or any financing you’ve taken out) normally has nothing to do with the cost basis of your home. You can buy a home for $200,000, take a $150,000 mortgage out when you buy it, then refinance years later with a loan for $300,000, but the mortgage balance has nothing to do with the price you paid for the home or the profit you might make (remember, you can always lose money) on the sale of the home.
The mortgage isn’t the driver when it comes to calculating the cost basis of the property and profit for tax purposes. In the simplest of terms, if you buy a home for $200,000 and sell it for $300,000 and we assume you had no expenses whatsoever in the purchase, ownership or sale of the home, you’d have a profit of $100,000 on the sale of the home.
But almost everyone has some costs associated with the purchase, ownership and (down the line) sale of the home. These get applied to your actual purchase price of the property and factor into the cost basis for tax purposes.
We’ve written about this topic in the past and find that our readers tend to understand the concept of profit much better than the IRS term of “cost basis.” While these terms are different, it’s just easier to
write about the profit in the sale of a home.
How do you figure out the profit on the sale of a home? First, you have to figure out what the home cost was for you to buy the property. While the purchase price is a starting point, you also likely paid closing costs and may have had other costs that the IRS allows you to consider as part of the purchase of your home. We’re not going to go into all of the allowable items here, and you can get more information at IRS. gov (search for Publication 523). This publication will
give you a list of the typical expenses that go into determining the cost of your home.
Likewise, if you put on a new roof, new kitchen or an addition, the IRS allows you to add those expenses to the cost of your home, but not the cost of simply redecorating or buying a new dining room table. Again, Publication 523 has a long list of improvements that go into increasing the cost basis for your home.
So, if you paid $200,000 for the home, had $10,000 in closing costs to buy the home and put in allowable
IRS improvements of $15,000 into the home, your cost basis of your home thus far would be $225,000.
When it comes time to sell, you’ll incur expenses including the broker’s commission, transfer fees and taxes, title insurance expenses, recording fees and legal expenses, among many others. If you add up these costs and they come to $30,000, that would also be added to your cost basis, which is now $255,000 ($225,000+$30,000).
So, how much did you sell your home for? Let’s say the sales price is
$300,000. Then, subtract the cost basis ($255,000), and you’ll see that your profit is $45,000.
We’ve simplified the process quite a bit, but you’ll see that the amount you owe your lender did not factor into how we got to the profit on the sale of the home. We hope this information helps you as you move forward to sell your home and figure out if you have a profit on not under the eyes of the IRS.
So, what do you owe the IRS? Well, if you’re single and have lived in your home as your primary
residence for two out of the last five years, the IRS allows you to exclude from federal income taxes up to $250,000 in profits from the sale of a home. If you’re married, you get to exclude up to $500,000 in profits.
So, while the homeowner in our example might show a profit of $45,000, no federal income taxes should be owed.