Home Equity Debt Can Reduce Capital Gains Taxes

Capital gains earned from the sale of your home can lead to a huge tax bill. Learn how to minimize your capital gains bill by raising your cost basis through home improvements.

Mark Twain once said that he'd never use profanity "except in discussing house rent and taxes." If Uncle Sam makes you feel the same way, you'll need to tread lightly when it comes to selling your home.

Paying capital gains tax

When you sell a capital asset-like a stock or a piece of property-for a profit, the IRS wants a piece of the money you make. It's called the capital gains tax, and it can be one of the most frustrating parts of your tax bill. Fortunately, the IRS does have a special set of rules that apply to home sales. You can exclude the first $250,000 of home-sale profits from taxable income. (Married couples filing jointly can exclude up to $500,000.) These exclusions sound generous, but if you've owned your home for many years, they may not be generous enough.

Knowing your basis

Your home-sale profit is what's left after you subtract the cost basis from the selling price. The IRS discusses how to determine your basis at length in Publication 523, Selling Your Home. The key points are:

If you bought or built the home, the basis is your cost, including settlement fees and closing costs.

If you obtained the home as an inheritance, as a gift, in a trade, or from a spouse, the basis is fair market value. Inherited homes are usually valued as of the day the previous owner passed away. See your tax advisor for the rules governing gifts, trades, and spousal transfers.

Raising the basis with capital improvements

The IRS allows you to raise your basis by the cost of any capital improvements made to the home. A higher basis lowers your profits, which in turn lowers your tax liability. Capital improvements are additions, remodels, and other long-term upgrades. Examples include adding on a sunroom or overhauling a kitchen. Regular repairs and maintenance don't qualify.

When cash is tight, you can use a home equity loan or home equity line of credit (HELOC) to fund these improvements. Since your home has appreciated, you should have sufficient equity to support the financing. If you want to get the improvement projects done quickly and sell the home fast, look into a HELOC; they're easy to obtain and have low or no closing costs. If you have more time and you aren't sure when you're going to sell the home, consider a home equity loan, because it's not subject to interest rate volatility. Either way, be sure to select a debt product that doesn't have prepayment penalties.

With some planning, you can manage your tax bill and still realize a nice profit when selling your home. And you can save those profane phrases for more important things, like sporting events and rush-hour traffic.