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Maximizing Home Sale Gains: The Power of Keeping Improvement Records

When the selling price, after accounting for expenses, exceeds the original cost of one's primary home, any resulting gain would typically be subject to taxation. However, there is a provision in the tax law that allows for the exclusion of some or all of this gain from the seller’s income, provided certain requirements are met. Homeowners, for instance, must pass the 2-out-of-5-years use and ownership tests to exclude up to $250,000 (or $500,000 if both the filer and spouse qualify) of home sale gain. Additionally, this exclusion can only be used once in a two-year period, with exceptions in cases of unforeseen circumstances like a change in job location or illness.

To determine if there is a gain, one must understand the total "cost" of the home. This includes not only the original purchase price but also expenses incurred for home improvements during the ownership period. While homeowners may not keep a record of these improvements if they expect the gain from selling the home to fall within the exclusion amount, such records can be immensely beneficial for potential tax savings when the gain exceeds this limit.

Keeping detailed records of home improvements becomes crucial in several scenarios:

  1. Long-term Ownership and Significant Appreciation: In cases where a home is owned for an extended period, and there is substantial appreciation due to inflation, the gain may surpass the exclusion amount. Including improvement expenses in the cost calculation can help reduce the taxable gain.

  2. Conversion to Rental Property: If the home is converted into a rental property, both the cost and improvements are necessary to establish the depreciable basis of the property.

  3. Conversion to Second Residence: In some cases, the exclusion might not apply to the sale if the home is converted to a second residence.

  4. Casualty Loss: If a casualty loss occurs, and the homeowner retains the home after making necessary repairs, records of these repairs are crucial.

  5. Sale Before Meeting Use and Ownership Requirements: If the home is sold before meeting the 2-year use and ownership requirements, detailed records become indispensable.

  6. Reduced Exclusion Due to Unforeseen Circumstances: If an unforeseen circumstance leads to a reduced exclusion, and the home is sold before meeting the 2-year use and ownership requirements, having records of improvements is vital.

  7. One Spouse Retains Home After Divorce: In cases where one spouse retains the home after a divorce and is entitled to a $250,000 exclusion instead of the $500,000 exclusion available to married couples, keeping improvement records is essential.

  8. Future Tax Law Changes: Records of improvements can also be crucial in the face of potential future tax law changes affecting exclusion amounts.

While keeping records may not be the most enjoyable task, consider the potential consequences if you sell your home at a gain and a portion of it cannot be excluded. You may face capital gains tax at a higher rate due to being pushed into a higher tax bracket. Therefore, it's prudent to maintain receipts, invoices, contracts, and payment records for significant improvements. Retain these documents for at least 3 years (some recommend 6 years) after the later of the due date of the tax return on which the home sale is reported or the date the return was actually filed. Depending on your state's rules, the retention period may be longer.

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