No Capital Gains Tax on Your Home Sale?
Yes, It’s Possible Under Section 121—But You Must Keep Your Receipts!
Saving receipts may seem like an annoying task that your tax accountant keeps reminding you to do—I know, it’s frustrating. But it’s absolutely essential when it comes to claiming deductions.
Generally speaking, to claim any deduction, the IRS requires receipts as proof that you actually spent the money. Without them, your deduction may be disallowed.
To illustrate this important point, I would d like to share a hypothetical scenario.
I’ll use Section 121, the primary residence gain exclusion provision, as an example because it’s a crucial tax code rule that all physicians should know.
A Quick Review of Section 121 and How It Applies
According to IRS Section 121, up to $500,000 of capital gains from the sale of your primary residence may be tax-free, provided that you and your spouse lived in the home for at least 2 of the last 5 years before the sale.
However, what many people don’t realize is that keeping records of all money spent on home improvements may be crucial to fully maximizing the Section 121 exclusion and saving thousands of dollars in taxes.
Here’s an example:
Drs. Catz and Martini’s Home Sale Scenario
Purchased home in Oakland in 2014 (lucky!) after getting married.
Made significant home improvements over the years using hired contractors.
Sold the home in 2024.
Key Financials:
Purchase Price: $1M (including escrow and fees)
Sold Price: $2M (including selling costs)
Improvement Costs: $500K
Capital Gains Calculation:
$2M (sold price) - $1M (purchase price) - $500K (improvements) = $500K (capital gains)
As long as Drs. Catz and Martini can prove they spent $500K on improvements, they can use Section 121 to exclude the entire $500K gain from taxation.
What If They Don’t Have Proof?
If they do not have receipts or other documentation for the improvements, the IRS may treat the improvement cost basis as ZERO.
What happens then?
If the IRS disallows the $500K in home improvements (though full disallowance is unlikely due to the Cohan Rule, Cohan v. Comm., 39 F.2d 540 (2nd Cir. 1930)), the capital gain calculation changes significantly:
Revised Capital Gains Calculation (No Proof of Improvements)
$2M (sold price) - $1M (purchase price) - $0 (no proof of improvements) = $1M capital gain.
Under Section 121, only $500K of the gain is excluded.
The remaining $500K becomes taxable as long-term capital gains.
Potential Tax Consequences
For a high-income couple like Drs. Catz and Martini, with $1.1M in combined wages, their tax rate on their capital gains could reach 40%+, broken down as follows:
Federal Long-Term Capital Gains Tax: 20%
California State Tax: 12.3%
Net Investment Income Tax (NIIT): 3.8%
Estimated Tax Bill on $500K of Taxable Capital Gains
40% × $500K = $200,000+ in taxes!
The Lesson: SAVE YOUR RECEIPTS!
To claim deductions, you must have receipts to substantiate your expenses. Proper documentation of home improvement costs can save you a significant amount in taxes.
Hold on to these records—they’re worth their weight in gold!