Will You Pay Capital Gains Tax When You Sell Your Home?

Times change.

When you were younger and you had a family, having a lot of space in your home made sense.

Multiple bedrooms and bathrooms, a finished basement, a big yard, etc.

However, now that the kids are out on their own and you’ve moved into the “retirement” phase of your life, your big house, and all the physical responsibility that comes along with it, is not as appealing as it once was.

Should you sell it and move into a home that is more suitable to your current lifestyle?

This is a question that’s in the forefront of many of our Relaxing Retirement members’ minds whom I speak with every day.

One of their stumbling blocks is in not knowing what the tax implications will be if and when they sell their home vs. keeping it and passing it on to their children.

This is a very important subject with a wide array of possible outcomes, so let’s walk through a brief example to cover all the bases.

Rick and Lucy

Let’s assume for a moment that we have a couple, Rick and Lucy, who are now 65 years old and have recently retired.

They have three children, two of whom are married.  And, a third who is engaged to be married in six months, but is working and living in an apartment in Boston.

Rick and Lucy purchased the home that they now live in back in 1983 for $280,000.  Back then, it seemed like all the money in the world, but it was worth it because it was a great house in a family neighborhood.

Right before they retired, they paid off their mortgage in full which included a second mortgage that they had taken out to help with college tuitions.

Today, because they purchased their home in a very nice town, they’ve been told by a local realtor that their home is currently worth $1,200,000.

Tax Implications

If Rick and Lucy decide to sell their home right now, what are the tax implications?

What if they keep their home and the kids inherit it?

To understand what the implications will be, you have to become familiar with the term “cost basis”.

Cost basis is a “tax” term which equals your total cost in an asset like a home.

In Rick and Lucy’s case, this starts with their purchase price: $280,000.

If they made permanent home improvements over the last 28 years, this would add to their cost basis.

In this case, let’s assume that Rick and Lucy made $170,000 worth of improvements over the years, including an addition and a swimming pool.

This now brings their cost basis up to $450,000.

If Rick and Lucy sell their home and walk away with $1,150,000 (after paying their real estate broker), they may exclude their “cost basis” or $450,000 from capital gains taxes, thus leaving $700,000 subject to capital gains tax.

Capital Gains Tax Exclusion

To spur economic activity, Congress passed a law that allows individuals to exclude $250,000 from the proceeds of the sale of your home, or a combined $500,000 if you’re married and own the property jointly.

(This law had many other variations over the years which dramatically changed people’s behavior)

So, in addition to being able to exclude their cost basis from taxes, Rick and Lucy may also exclude another $500,000.

To summarize, if they sell their home for $1,200,000, pay their realtor and walk away with $1,150,000, $950,000 is excluded from capital gains taxes.

To arrive at $950,000, we take their cost basis of $450,000 and their capital gains exclusion of $500,000.

However, $200,000 (the difference) is then subject to capital gains taxes which are currently 15% on the federal level.  If you live in Massachusetts, add another 5% tax.

In Rick and Lucy’s case, they’d owe approximately $40,000 in capital gains taxes if they sold their home today.

Step-Up in Basis

This changes dramatically, however, if Rick and Lucy decide to keep their home and pass it to their children at their death.

When you pass away, the cost basis in all your assets “steps up” to your date of death value!

This is significant.

In Rick and Lucy’s case, if the value of their home at their death was $1,200,000, and their children sell their home soon after their death, $1,200,000 is excluded from the sales price as far as capital gains taxes are concerned.

In other words, the kids would pay no capital gains taxes if they sold their house for that same amount.

That’s a $40,000 difference!

As a side note, if the kids keep the house for a few years and later sell it for $1,400,000, they’d owe capital gains tax on the growth since the date of their parents’ death, or $200,000.

The Lesson

The lesson in this Strategy of the Week is to know your cost basis in all your assets (your home, your investments, your business, etc.)

When you know your cost basis, you can make calm, rational decisions based on fact.  And, that’s how you want to make all your decisions.

If you’re having a tough time calculating your cost basis, let me know so we can help you.

Committed To Your Relaxing Retirement,

Jack Phelps

The Retirement Coach

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