Other than the “So, how’s the market?” question, the most consistent queries I get concern capital gains taxes.
Let me start off with a disclaimer: I am neither an accountant nor attorney, so I can give neither tax nor legal advice. I will cover some generalities related to capital gains, but I urge you to consult a professional with the specifics of your situation.
The good news is that your house has appreciated so much that you actually owe capital gains tax. The bad news is that you owe capital gains tax.
Q: I have heard the term “stepped-up basis” related to a home. What does it mean?
A: There are other cases where this will apply, but the main one I see is that upon the death of the first of the owners (husband or wife) of a house, the cost basis – the value the IRS uses to determine what you paid for the house – “steps up” to the market value of the house on his or her date of death. For example, Mr. and Mrs. Homeowner purchased their house in 1975 for $300,000 – this amount becomes their original cost basis. If their house is worth $3 million when either Mr. or Mrs. passes away, the new cost basis for their house would be $3 million.
Q: Why is the cost basis important?
A: When you sell your house, capital gains taxes are essentially calculated as a percentage of the difference between the cost basis and the sales price. The cost basis is determined by adding what you originally paid for the house plus all the improvements you made over the years. To qualify, they must be improvements, not just maintenance – for example, adding a new room, adding solar panels, upgrading the kitchen or bathrooms, adding a pool or installing new windows or doors.
Q: How is the sales price determined?
A: In nearly every case, it is simply the contract price – what you sell the house for. Transferring a house to a family member would be handled differently. The costs associated with the actual sale of the house can be deducted from the sales price. Costs such as commissions, title and escrow fees, staging and fixing up the house for sale will reduce the sales price for capital gains calculations.
Q: What about the homeowner’s exclusion?
A: When capital gains taxes are calculated, the first $250,000 in gains are excluded ($500,000 for a married couple).
Q: Why are capital gains calculations important?
A: There are two primary impacts.
• There may be a tendency for married couples to wait until one of them dies to essentially avoid the capital gains tax. This has the effect of reducing the inventory, which tends to make home prices rise.
• The savings can be substantial. Waiting until one half of a couple dies could save hundreds of thousands of dollars.
Q: Can you simplify how to calculate capital gains?
A: The formula is sales price - cost basis - improvements - selling costs - exclusions = your taxable capital gains. Apply your appropriate tax rate to the capital gains and that will be your approximate tax liability.
For example, say you bought your house for $300,000 many years ago; after adding $200,000 in improvements over the years, you and your spouse sell the house for $3 million and it costs you $175,000 in fees, fix-up, staging, etc., to sell it.
If you are still married: $3 million - $300,000 - 200,000 - $175,000 - $500,000 = $1.825 million in gains x 35% (estimated tax rate) = approximately $630,000 in capital gains tax due.
If you sell after one spouse dies: $3 million - $3 million = zero capital gains tax due.
There are other factors involved that you should discuss with your attorney, your accountant and your estate/trust planner before making any important decisions.
Owen Halliday is a longtime Los Altos resident and manager of the Sereno office in downtown Los Altos. Email comments, questions and potential column topics to [email protected] For more information, call 492-0062.