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Home Sale Math

by Tim Isbell     (#realestate, #retirement)

posted 8/2013, revised 12/2013, revised 6/2014 to incorporate the effects of California Propositions 60 & 90

Many people think about selling their house but aren't sure where to start. This web page is a place to learn how the numbers work before you meet with a real estate or tax professional. Because the tax code and other things change over time and what geography you live in, be sure to seek up-to-date advice from a tax professional and a local real estate professional before you take action. 

I am not an expert in either area. But in June/July 2013 Robin and I sold our home of 19 years to begin downsizing. In the process, we learned some things worth passing along. Hence, this web page.

While I'm placing this web page in the Personal Finance > Retirement section of my site, it is equally useful when selling your own residence at any stage of life.

A home sale example

The chart below is a hypothetical example designed for learning.

Assume that you and your spouse purchased your first home 30 years ago. It is in a strong market where the selling price of homes grew 5% per year including inflation (of about 2.5% per year). This appreciation rate is much higher than in most of the U.S., where the typical appreciation is more like 0 - 0.5% above inflation. Using the higher rate helps the numbers in our example illustrate the full range of the math, and because it does reflect reality here in Silicon Valley (the San Francisco Bay Area of California). 

Notice that I annotated the left-hand column with letters. The section just below the chart provides some comments about each row.

Home Sale Math Example

The chart is a Google Sheet, which you can download here to your Google Docs account, or to Microsoft Excel. Then you can insert your numbers.

Understanding the rows

Line a: Selling Price

Let's say you listed you home for $870,000 and after some bargaining, you settled on a contract with a buyer for $864,000. So, that's your selling price.

Line b: Brokers' fee

Most people use a broker to sell their house; in California, the standard broker fee is 6%. This is a lot of money, so shop around for a good, local broker.

You, the seller, pay the entire broker fee; half goes to your agent, and half goes to the buyer's agent. Sometimes you can negotiate a lower broker fee, perhaps 4-5%. This is more likely if your broker also finds the buyer and serves as the buyer's broker. But a shared broker has drawbacks.  He/she is not just focused on optimizing your financial return, he/she is equally focused on optimizing the buyer's financial return. 

In some areas, you may be able to sell without a broker. But beware: this is very hard for a layperson to do and you probably won't save any money. Our experience is that a good broker is worth their commission.  

Line c: Other Selling Costs

Selling costs include things as fees to the bank that financed your home, county property taxes up to the date closing, title insurance, escrow fee, city/county transfer fees, home warranty, geological survey, property inspection(s), termite inspection, and so on. Some selling costs may be negotiable with the buyer. 

Line d: Net from Sale

This is the amount you actually receive from the sale at closing. It equals the selling price minus the broker fees and selling costs.

Line e: Purchase Price (original house)

This is what you paid for the house 30 years before. Hopefully, you kept the closing statement from that purchase because that's where you'll find the exact number!

Line f: Purchase Costs

That closing statement from 30 years ago also itemizes purchase costs such as fees from the bank that lent you the money, recording fees, notary fees, lender's title insurance, property taxes, etc.

Line g: Improvements

This line contains all the improvements you put into the house over 30 years. It adds to the cost basis, thereby reducing your capital gain tax bill. S
o you'll want to keep records of your improvements. Photos of significant improvements are also a good idea. IRS rules need some interpretation to distinguish improvements from maintenance costs, so talk with a tax professional. If you use Quicken (or something like it) to manage your finances, you can "Tag" each improvement expense with something like "House - cost basis increase", regardless of which "Category" you put it in. 

If you didn't keep track of the cost of improvements, it's still worth doing your best to generate a list, gather all the receipts you can find, and take photos of your improvements.

Line h: Cost Basis

This is the original purchase price, plus the original purchase costs and the improvements over all the years you owned the house. The IRS considers this the total amount of money that you put into the house.

Line i: Capital Gain

The increase in the "net from sale" over the "cost basis" is your capital gain (for tax purposes). Assuming you owned the home for at least one year, this is your "long-term capital gain." 

In our example, the long-term capital gain is $540,000. Stop and think about this: Over 30 years you made $540,000 gain from the house. That's $18,000 a year without paying any taxes on it along the way. And you also got a yearly tax deduction for the interest on your loan(s)!

Now let's see how much tax you will owe when you sell it. Let's also assume that you and your spouse had $60,000 of ordinary income in the year of your home's sale and that you file taxes jointly. 

  • If you had to pay taxes on all this ($60,000 plus $540,000) at the ordinary income rate, you would owe about $183,000 to the IRS. That's huge! Fortunately, that's not the way home sale math works. 
  • Instead of treating this $540,000 as ordinary income, treat it as a long-term capital gain. So your tax bill for $60,000 of ordinary income and $540,000 of long-term capital gains would come to about $104,000. That's a lot better, but still huge! Fortunately, there's more good news, read on.

Line j: Tax Exemption

Believe it or not, if a couple lives in their house at least two years over the last five years before the sale, the government allows a $500,000 long term gain tax exemption. (For an individual owner, the exemption is $250,000.) This exemption makes a huge difference.

Line k: Taxable Gain

The $500,000 exemption means that instead of owing long-term capital gains tax on $540,000, you and your spouse own the tax on only $40,000.

  • When you factor this into the tax tables, your tax bill comes to about $8,500. Much of which is due to the tax on your ordinary income of $60,000 from your normal job in the year of the sale.

This is amazingly good news!

To play around with tax calculations for yourself, try this Tax Calculator.

You may wonder why the U.S. government subsidizes home ownership so heavily. It started in the 1920's and it was based on the premise that citizens needed to save more in order to finance their later years. The government realized that young and middle-aged people were more likely to put money, month-after-month, into their personal home than into any other investment. Since home values tend to track (or slightly exceed) the rate of inflation, this strategy made sense - and still does. For more on this read Owning a Home Isn't Always a Virtue by Robert Shiller.


The 3.8% Medicare Tax

This is a new tax in 2013 which applies only to very high-income people. Specifically, the Medicare Tax applies to couples with more than $250,000 ($200,000 if single) in investment income. In our example, the long-term capital gain after the exclusion adds $40,000 to the couple's investment gains for the year. So unless the couple had a lot of other investment gains, the house sale will not trigger any Medicare tax. For more on this, Google it or read The New Medicare Tax and You.


State taxes

Good question. Most states have some sort of income tax on the capital gain from the sale of a personal residence. The tax varies from state to state. We live In California, a very high-tax state where there is no preferential treatment long term capital gains. So the California ordinary income tax rate applies to long-term gains on a personal residence. In California, this progressive tax very soon reaches the max of nearly 10%. 

Fortunately, California allows the same $500,000 exemption that the IRS allows! Even so, the California state tax on every dollar beyond the $500,000 is significant.


Taxes for our heirs

More good news: For most of us (except those with extremely large estates) there is no tax due upon our death. 

Let's say the couple in our example dies and in their will/trust they leave the house to their kids. The kids get the house appraised as of the time of death and the cost basis for the house gets "stepped up" to that appraised value! So the government "zeros out" all the capital gains and the kids get the house tax free!

As it turns out, this is the same way all long-term assets are handled at death. If you bought Google shares at their Initial Public Offering price several years ago, and sell those shares the day before you die, your estate must pay tax on all that long term capital gain (with no exemption such as in a personal residence). But if you die and leave the Google shares to your kids, the cost basis of those shares "steps up" to the price of Google on the day you died! So your heirs owe no tax on the gain!

There are only a few people with so much equity in their home that the long-term capital gain is significantly larger than $500,000. If you are fortunate enough to be in this category you may decide to keep the house until you die instead of paying the tax. Then the maximum value passes along to your heirs. 

If you have this much equity in your house, then as you get into the last few years of life the decision of whether to sell and pay the tax or hold onto the house so that your heirs get it at the "stepped-up" cost basis becomes important to your family. If that's you, talk with a tax professional who can help you understand the trade-offs between selling your residence to generate living money, taking out a reverse mortgage on your house, or some other strategy.


The bottom line

Because of the $500,000 tax exemption on the long-term capital gains from selling a personal residence, the vast majority of U.S. residents can sell their house without paying any tax at all to the federal or the state government! In the rare cases where owners do make more money on the house than the $500,000 exemption, they pay tax at the lower long-term capital gains rate! That is a very, very sweet deal.


Local Property Taxes

This varies a lot depending on what state/county you live in. In several California counties, Proposition 60 allows homeowners who are 55 or over to transfer their property taxes one time from their current residence to a less expensive residence in the same county. Proposition 90 extends this to moves between participating counties. If you owned your home for many years it's assessed value is probably lower than what will be assessed for your downsized house, so transferring the property taxes saves money every year. To take advantage of this in Santa Clara County, check out this  Senior Citizen - Tax Base Transfer link. Follow the link to the page where you can download the form to fill out and file with the county. Be sure to note the time limits on your filing.

Regardless of your age, if you downsize and do substantial remodeling soon thereafter, some of it may fit the definition of "New Construction." If you file this with the county within prescribed time limits, you will not be assessed for this construction. You can file this on the same form in the previous paragraph. When you get to the form, note the place to enter in the cost and date of completion of the "New Construction." 

Be aware that these Proposition 60/90 benefits are not available in all California counties. But these do apply in Santa Clara County where we live so these propositions are worth a lot. I don't know if this sort of property tax relief exists in other states. But it's certainly worth checking out.


Okay, now you are ready...

... to have that meaningful talk with a real estate and a tax professional.

Please send me your comments (use the Contact Tim function in the left sidebar of this web page).


Thanks,

Tim



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