With homes prices soaring in this red-hot real estate market there are always tax implications to keep in mind. Now more than ever homeowners need to be familiar IRS rules and how they will impact the tax they may owe.  Understanding the Section 121 Exclusion and Cost Basis of your home are keys to mitigating taxes owed.

Section 121 Exclusion

If you have a capital gain from the sale of your main home, you may qualify to exclude 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. 

In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test. You are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.

If you receive an informational income-reporting document such as a 1099-S you must report the sale of the home even if the gain from the sale is excludable. Additionally, you must report the sale of the home if you cannot exclude all your capital gain from income.

Cost Basis  

Basis is the amount your home is worth for tax purposes. When you sell your home, your gain or loss for tax purposes is determined by subtracting its basis on the date of sale from the sales price (plus sales expenses, such as real estate commissions). The larger your basis, the smaller your profit will be, reducing your tax liability. If you sell your home for less than its basis, you will have a loss. However, losses incurred on the sale of a personal residence are not deductible.

If you have purchased your home, your starting point for determining the property’s basis is what you paid for it. Logically enough, this is called its cost basis. Your cost basis is the purchase price, plus certain other expenses. You use the full purchase price as your starting point, regardless of how you pay for the property—with cash or a loan.

Certain fees and other expenses you pay when buying a home are added to your basis in the property. Most of these costs should be listed on the closing statement you receive after escrow on your property closes. However, some might not be listed there, so be sure to check your records to see if you have made any other payments that should be added to your property’s basis. These include real estate taxes owed by the seller that you pay, settlement fees and other costs such as title insurance.

Your starting basis in your home must be reduced by any items that represent a return of your cost. These include:

• depreciation allowed or allowable if you used part of your home for business or rental purposes
• the amount of any insurance or other payments you receive as the result of a casualty or theft loss
• any amount you receive for granting an easement.

You must increase the basis of any property by:

• the cost of any additions or improvements
• amounts spent to restore property after it is damaged or lost due to theft, fire, flood, storm, or casualty
• tax credits you received after 2005 for home energy improvements
• the cost of extending utility service lines to the property, and
• legal fees relating to the property, such as the cost of defending and perfecting title.

In addition, assessments for items that tend to increase the value of your property, such as streets and sidewalks, must be added to its basis. For example, if your city installs curbing on the street in front of your rental house, and assesses you for the cost, you must add the assessment to the basis of your property.

The most common way homeowners increase their basis is to make home improvements. Improvements include any work done that adds to the value of your home, increases its useful life, or adapts it to new uses. These include room additions, new bathrooms, decks, fencing, landscaping, wiring upgrades, walkways, driveway, kitchen upgrades, plumbing upgrades, new roofs.