Question

The Pratts (a married couple) purchased their home for $400,000. They have lived in the home, as their main residence, for six years. While they lived at the house, the installed a new roof costing $15,000 and added a small addition costing $25,000. At the end of the sixth year, they sold the home for $700,000 and paid a 10% commission to the real estate agent who listed and sold the home for them. Based on this information, answer the following four questions,

1. What is the adjusted basis in their home?

2. What is the realized gain on the sale of their home?

3. What amount of the gain are they required to include in their taxable income?

4. Assume all the above facts are the same, except that the Pratts have only lived in the home for one year and decided to sell it because they didn’t like their neighbors. How much of the gain are they required to include in their taxable income?

Answer 1

1. Adjusted basis of the house = Purchanse price of the home + any incidental expenses incurred to purchase the same + cost of improvements + legal expenses.

In this case, Adjusted Basis = $400,000 + $15,000 + $25,000 = $440,000.

2. Realised Gain = Net Sale Proceeds - Adjusted Basis

Net Sale Proceeds = Gross Proceeds - Expenses incurred to sale the property

= Gross Sale Proceeds - commission paid to the real estate agent

= $700,000 - 10% of $700,000

= $700,000 - $70,000

= $630,000

Hence, Realized Gain from sale of Home = $630,000 - $440,000 = $190,000

3. As per IRS publication 523, married couples filing joint income tax returns can exclude gain from sale of their principal residence upto a maximum limit of $500,000 provided they meet the certain conditions or tests.

A. Ownership - The home must be owned for 24 months i.e. 2 years out of the last 5 years period leading upto the date of sale. In case of a married couple filing jointly, only one spouse has to meet the ownership requirement.

B. Residence - The home must be owned and used for 24 months i.e. 730 days out of the last 5 years period leading upto the date sale as their residence. It can be any days totalling upto 730 days and not consecutive days within the overall 5 years period. Unlike the ownership requirement, both the spouses have to meet this requirement.

C. There must not be a sale of another house within the 2 years period before the date of sale where gains realized from the sale of the property was excluded.

In this case, the Pratts owned and used the home as their main home for the last six years. Assuming that they did not sell any other property 2 years before the sale of this property, they meet all the conditions to be eligible to exclude their gain from the sale of the main home. As they are filing jointly they are eligible to exclude realized gain upto a maximum of $500,000. As the realized gain is $190,000, hence they can exclude the entire gain. So under the present situation they are not required to include any gain from the sale of their main home in their taxable income.

4. If they live in the home for one year within the last 5 years period leading upto the date of sale, then they are not able to meet the residence requirement to be eligible to exclude their relized gain from the sale of their main home. They are also not eligible for the partial exclusion as they did not sell the home because of one of the following reaons ----------- Work related move, health related move and unforeseeable events. They sold the property as they did not like their neighbours. This is not a valid condition for claiming partial exclusion. Hence they need to include the entire realized gain of $190,000 in their income tax return as taxable income.