INVESTMENT ANALYSIS OF A RESIDENCE
Appreciation /
Deductibles / Tax liability / Gains tax exclusion
Investment analysis examines the economic performance of an investment. The analysis includes costs, income, taxation, appreciation, and return.
A property acquired and used as a primary residence is an example of a non-income property. If a portion of a residence is used for business (i.e., a home office), this portion only may be treated as an income property for tax purposes. Since, by definition, a non-income property does not generate income, its value as an investment must come from one or more of the other sources: appreciation, leverage, or tax benefits.
Appreciation
Appreciation is the increase in value of an asset over time. A simple way to estimate appreciation on a primary residence is to subtract the price originally paid from the estimated current market value:
Current value – original price = total appreciation
For example, if a house was bought for $300,000 and its estimated market value now is $400,000, it has appreciated by $100,000.
| Original price: | $300,000 |
| Current market value: | $400,000 |
| Total appreciation: | $100,000 |
Total appreciation can be stated as a percentage increase over the original price by dividing the estimated total appreciation by the original price.
Deductibles
The primary tax benefit available to the owner of a non-income property is the annual deduction for mortgage interest. The portion of annual mortgage payments that goes to repay principal must be subtracted to determine the amount paid for interest. Principal repayment is not deductible. Furthermore, depreciation is not allowed for non-income properties.
Tax liability
The seller of a principal residence may owe tax on capital gain that results from the sale. The IRS defines gain on the sale of a home as amount realized from the sale minus the adjusted basis of the home sold.
Amount realized. The amount realized, also known as net proceeds from sale, is expressed by the formula:
The sale price is the total amount the seller receives for the home. This includes money, notes, mortgages or other debts the buyer assumes as part of the sale.
Costs of sale include brokerage commissions, relevant advertising, legal fees, seller-paid points and other closing costs. Certain fixing-up expenses, as discussed further below, can be deducted from the amount realized to derive an adjusted sale price for the purpose of postponing taxation on gain.
For example, Larry and Mary sold their home for $350,000. Their selling costs, including the commission they paid Broker Betty and amounts paid to inspectors, a surveyor, and the title company, amounted to ten percent of the selling price, or $35,000. The amount they realized from the sale was therefore $315,000.
Adjusted basis. Basis is a measurement of how much is invested in the property for tax purposes. Assuming that the property was acquired through purchase, the beginning basis is the cost of acquiring the property. Cost includes cash and debt obligations, and such other settlement costs as legal and recording fees, abstract fees, surveys, charges for installing utilities, transfer taxes, title insurance, and any other amounts the buyer pays for the seller.
The beginning basis is increased or decreased by certain types of expenditures made while the property is owned. Basis is increased by the cost of capital improvements made to the property. Assessments for local improvements such as roads and sidewalks also increase the basis. Examples of capital improvements are: putting on an addition, paving a driveway, replacing a roof, adding central air conditioning, and rewiring the home.
Basis is decreased by any amounts the owner received for such things as easements.
Gain on sale, if it does not qualify for an exclusion under current tax law, is taxable.
Gains tax exclusion Tax law provides an exclusion of $250,000 for an individual taxpayer and $500,000 for married taxpayers filing jointly. The exclusion of gain from sale of a residence can be claimed every two years, provided the taxpayer
- owned the property for at least two years during the five years preceding the date of sale;
- used the property as principal residence for a total of two years during that five-year period;
- has waited two years since the last use of the exclusion for any sale.
Losses are not deductible, and there is no carry-over of any unused portion of the exclusion. Postponed gains from a previous home sale under the earlier rollover rules reduce the basis of the current home if that home was a qualifying replacement home under the old rule.
