Capital gains tax based on original price or refi mortgage?
We live in Missouri, in the US, and purchased our first home for $43,000 in 1997. It was our primary residence for 3 years, during which we refinanced the mortgage for $50,000. After 3 years we turned it into a rental property and again refinanced as an investment property, this time for $60,000. After putting just over $20,000 in improvements into the property this year and last year we recently sold it for $78,000. My question is, are the capital gains taxes based on the original purchase price 10 years ago or on the amount of the mortgage we just paid off when we sold it?
Any financing amounts whether for the purchase or re-fi have nothing to do with the capital gains calculations.
The formula is Net Proceeds – Adjusted Basis = Gain.
Net Proceeds is fairly simple — whatever you sold it for less any selling expenses such as commissions and non-recurring closing costs. So, if you paid a 6% commission ($4,680) and $1,000 in closing costs, your net proceeds would be $72,320.
Adjusted Basis is where it gets tricky, especially as you rented out the property. You start with the purchase price — $43k in your case. Then you add any improvements, $20k in your case for a total investment of $63k. Now you must subtract any depreciation allowed OR ALLOWABLE while you held the property as an investment. That "OR ALLOWBLE" can get you since you must adjust for depreciation even if you didn’t take a depreciation expense deduction while renting it out. So, for sake of argument you took a total of $9,500 in depreciation deductions over the years (an amount that I could justify, by the way, if I were an IRS auditor) then you subtract that from your total investment of $63k to arrive at an adjusted basis of $53,500.
Subtract your Adjusted basis of $53,500 from the net proceeds of $72,320 and you get a taxable gain of $18,820. Since you don’t qualify to exclude the gain from the sale you’ll pay capital gains tax on the entire amount. But since you held it for over 1 year, the gain is taxed at the long term rate, normally 15%. However if your tax bracket is already 15% or lower, the rate is 5%. Assuming that your tax bracket is higher than 15%, the total tax due from the sale would be $2,823.