Real Estate Matters: Property owner questions tax implications on sale of home and additional landscaped lot
Q: We have two combined lots that we bought in 1984 for a total cost of about $50,000. A 100-year old cottage sits on one lot and the other lot is a landscaped garden with no structures. Over the past 37 years, we have spent quite a bit of money on landscaping, fencing, a new roof, a new garage and a complete gut job to the main floor and attic of the house.
We have been offered over a million dollars for the combined properties. A buyer will likely tear our house down and build one mega-mansion across the two properties. We are moving to a senior community. What kind of taxes are we facing? There is a rumor of a one-time $500,000 break on taxes, but is that just on the house?
A: The great news for you is that the “rumor” is true. If you are married, own a home and use it as your primary residence for at least two out of the last five years, you get to exclude $500,000 of profit from federal income taxes. Singles get to exclude up to $250,000 in profit.
More good news: Under current federal tax law, you can take this exclusion every 24 months, so long as you live in the property for two out of the last five years as your primary residence. (There are a few other limitations that you’d expect from the Internal Revenue Service, and rules that cover a scenario where you might have lived in the home as your primary residence for only 18 months instead of 24.)
Of course, that won’t quite cover your expected profit, but we’ll get to how you calculate that in a moment.
The interesting variation in your question is that you have two combined lots. If the two lots were (and continue to be) used as a single property, we think you should be able to claim that the entire property was your primary residence.
If the original lot had the house and the second lot was purchased to provide a side yard or backyard, you could take the position that both lots comprised your home, even if you could have sold the vacant lot to a different person. We say that, but if you filed income tax returns and treated the lot as an investment property over the years, you might have to allocate your profits between your primary residence and the vacant lot (that functions as your side yard).
Let’s look at how much you’ll owe, if anything, since you put quite a bit of money into major improvements over the years. While you didn’t give us any details, it’s hard to imagine a gut rehab would cost less than $200,000. We’ll assume that amount, plus the $50,000 you spent to buy the property. The Internal Revenue Service counts both of these toward your basis into the home.
“Basis” is the term the IRS uses for what most of us would think of as the amount of money we’ve sunk into the property to buy it and then to complete any structural or material improvements, including the new roof, major remodeling, an addition, the new garage, new electrical or plumbing, etc. Basis also includes the cost to buy or sell the home. For more information on what goes into your basis, you can look at IRS publication 523 at www.irs.gov.
If we assume that the basis is $250,000 and you’re now going to sell the home for $1,000,000, you’ll have $750,000 in profit. The IRS would not tax you on the first $500,000 (as you are married) but the IRS would tax you on the balance of the profit of $250,000.