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The National Jump In House Values and the Power of Home Improvements to Offset Capital Gains Taxes

Dallas-Fort Worth Home Real Estate Has Seen Dramatic Value Increases

House values continue to rise in the low interest rate, post-recession economy. Homeowners are experiencing this increase not only in East and West coast cities like New York, Los Angeles, Boston, and San Diego, but here in Dallas-Fort Worth as well.

In fact, according to Allie Beth Allman & Associates’ Weekly ALLMANAC for June 12, 2015, North Texas home prices jumped 14 percent in May 2015—one of the largest yearly gains on record. According to the local real estate leader, home prices in the Dallas-Fort Worth area have seen a more than 40 percent increase in the last five years. National surveys show that DFW has the largest annual price gains in the United States, rising about three times the long term average rate of residential appreciation for the area.

Partially offsetting the increase in home values, however, is one of the tax code’s best tax breaks, the home-sale exclusion. Through the tax code, the U.S. recognizes the importance of home ownership by allowing a homeowner to exclude up to $250,000 of his or her capital gain from taxation.  For married couples filing jointly, the exclusion is $500,000.  However, as home values continue to rise, capital gains on sales exceeding the exclusion amounts may result in hefty and unexpected federal taxes up to 23.8 percent.

Sizing the issue prompts the question: how many homes in DFW would be subject to tax if sold today? Zillow estimates that 1.2 percent of DFW homes currently owned by single homeowners would be subject to federal taxes for real estate gains of more than $250,000; and that 0.3 percent of homes owned by married homeowners would be subject to federal taxes for more than $500,000 in real estate gains. The percentages of homes sitting on taxable gains in DFW are not as acute as those in some parts of the country. In San Francisco, for instance, a quarter of all homes already have unrealized gains of more than $250.000. Similarly, in San Jose, California, more than one-third of the homes have a gain of more than $250,000.

In ten years, assuming a 3.5% annual increase in home values, projects that the number of DFW homes that surpass the tax shield threshold will rise to 10.5 percent for single homeowners and 2.1 percent for married homeowners.  Again, the numbers are more dramatic in other regions of the country, particularly for coastal cities, where based on Zillow’s projection, 77.2 percent of the individually owned homes in San Francisco will see a tax bill. In San Jose, it’s 86.6 percent of homes.

As real estate prices climb, so could the percentage of homes subject to taxable gains. Conversely, the numbers could drop, if, according to Zillow, homeowners did not move houses or make home improvements during that period. Zillow’s projection also assumes there is no change to the $250,000 and $500,000 home sale tax exclusion during this ten year period.

As a rule of thumb, if you’ve owned a house long enough in a neighborhood with steadily increasing values—say in the Park Cities—you could have a taxable gain on the sale of your house.

Home Improvement Receipts to the Rescue

These increases in real estate value could certainly decrease individual’s projected income from selling their home; it could particularly affect those who plan to use that money to finance their retirement. But homeowners have a secret weapon – receipts for home improvements. The costs of home improvements count against the gains, sometimes as much as six figures for just one home remodeling project.

By way of background, IRS Publication 523 details the tax rules applicable to selling your home.  Generally, the gain on sale is calculated as the sales price less any fees and closing costs, less improvements, and less the home’s original purchase price. The tax rules for home sales can be complex, for example, although home owners normally don’t pay any capital gains taxes on amounts below the home-sale exclusion amounts, you must be living in the house for two of the five years before the sale in order to waive taxes if you are below the $250,000/$500,000 cut-offs.

Home improvement projects that can be deducted from capital gains above the $250,000/$500,000 limits include decks and patios, landscaping (including sprinkler systems), pools, new roof or siding, kitchen remodeling, insulation, installation of utility services such as fiber charges (bundled internet, telephone and television access). You can include any additional electrical outlets as well as legal, title, and recording fees from your home sale closing.

But here’s the home improvement caveat – repairs don’t count. Painting is maintenance, as is refinishing wood floors. If you install brand new wood floors, that is considered a home improvement. If you built your home from scratch, the purchase of the land, materials and fees paid to contractors all count as the original purchase price of your home. But if you did the project yourself, or cajoled friends to helping you, that doesn’t count.

Also, if you live in a condo or townhouse community with homeowners’ association fees, some of your monthly charges and special assessments may count. But again, you need receipts from the property management agent. In fact, you need receipts for every improvement you make, a fact that many homeowners aren’t told when it comes time to close the sale.

Like-Kind Exchanges Don’t Apply to Personal Residences

This is a good time to mention the like-kind exchange, as it applies only to investment and business properties and not to personal residences. The like-kind exchange provides an exception and allows you to postpone paying taxes on the gains from sales of real estate investment and business properties if you reinvest the proceeds into similar property.

IRS Publication 523 also has many carve-outs and exceptions, as well as exceptions to the exceptions, so it is best to consult a tax professional if you are: a member of the military, newly remarried couples who already own homes, people who moved due to job transfers, nursing home residents who kept the homes they used to live in, widows or widowers, people who rebuilt after a fire, flood or other natural catastrophe, and people who sold their homes before 1997 and then reinvested their capital gains into their current homes.

Also, if you acquired your home as a gift or an inheritance, if you used it as rental property at some point, or utilized it to run a business, you should check with a tax professional. If you received a first-time home buyer’s credit in 2008, you should also call your local tax professional.

Finally, there are a couple other points worth mentioning. A capital loss, such as from the stock market, can later be used to offset a large gain from a home sale.

Also, home sales in states where home values rose substantially, such as New York of California, is typically where people borrow money against their homes, spend it, thus depleting the equity. Then when they sell their homes and there’s a capital gain even after repaying the mortgage and the home equity loan, they find that there’s less money to keep because it has been eaten up by their tax bill.

Always keep in mind that house values could certainly elevate significantly in all parts of the country. So keeping abreast of home improvements and the federal taxes on capital gains is important no matter where you own a home.

Mckinnon Patten is an CPA firm with a full range of services, including providing comprehensive tax, accounting and advisory services to a full range of real estate entities and property types. 

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