Selling your home? Improve the tax outlook ? Business ...

One of the biggest tax breaks on the books is the federal income tax exclusion for gains from principal residence sales. If you qualify, you can pocket a home sale profit of up to either a quarter or a half a million dollars federal income-tax free?no strings attached.

But the giant home sale exclusion might not be enough if your home has appreciated hugely since you bought it. You still may have a king-size tax to pay when you finally sell your castle.

Strategy: Keep good records of home improvements. These expenses increase your tax basis for home sale calculation purposes (see box below). So, when you finally do sell your home, the higher basis reduces or eliminates the taxable gain.

Here?s the whole story: If you?ve owned and used your home as your principal residence for at least two of the previous five years, you can elect to exclude from tax up to $250,000 of home sale profit if you?re a single filer; $500,000 for joint filers. There are no limits on the number of times you can claim the exclusion.

The gain for purposes of the exclusion is the difference between the selling price and your adjusted basis in the home. For example, your basis may have been reduced to reflect rollovers from prior home sales under old-law rules. On the other hand, certain home improvements can increase basis to cut down the taxable gain.

Example: The proof is in the pudding

Let?s say you and your spouse bought your first home for $100,000 and sold it for $400,000. Then you bought your current home for $450,000. Under the rules in effect at that time, you avoided any current tax by rolling over the $300,000 gain from selling the first home into your current home.

During the past few years, you?ve made a number of significant improvements, including an in-ground pool, deck and finished basement. The total cost of the improvements was $125,000. Now you?re looking to sell the home for $750,000.

At first glance, you might think you would owe no tax on the home sale. Reason: Your assumed $300,000 profit ($750,000 ? $450,000) is covered by the $500,000 home sale exclusion for joint filers. But your actual initial basis in your current home was only $150,000 (purchase price of $450,000 ? $300,000 deferred gain that was rolled over from the sale of your first home).

Even after you claim the home sale exclusion, you?d have a taxable gain of $100,000 ($750,000 ? $150,000 basis ? $500,000 home sale ?exclusion).

As long as you can document the $125,000 of home improvements, you can increase the basis of your current home to $275,000 ($150,000 as calculated above + $125,000). So your gain now comes to only $475,000 ($750,000 ? $275,000)?less than the $500,000 maximum gain exclusion for a married joint-filing couple. Bottom Line: Your entire gain is tax-free!

Besides tracking recent home improvement expenditures, comb over past credit card statements and checkbooks for proof of additional home improvement costs that you might have forgotten.

Tip: Maintain a logbook, ledger or other record of expenditures that you?re adding to the basis of your home. Make backup copies of electronic files.

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