My last column on capital gains created a hailstorm of emails which could be divided into two camps: determining basis and the two-year live-in requirement. I'll deal with each individually and present some resources for further research for those who want all the details.

First of all, a couple of CPAs gingerly pointed out I miscalculated the basis in my example. I stated that basis was determined by the balance of your mortgage at the time of the sale of your property. It's actually the price you paid for the home. What I was thinking was not what I wrote – ever have that happen? My apologies and here's how you determine your basis.

When calculating your capital gains, you must first understand your basis. "Basis is the amount of your investment in property for tax purposes," according to IRS Publication 551. "Use the basis of property … to figure gain or loss on the sale or other disposition of property. You must keep accurate records of all items that affect the basis of property so you can make these computations." (You can read up on this at www.irs.gov.)

Generally, the basis of your property is determined by the cost you incurred to take possession of it. When you bought your house, the price you paid is the beginning of your basis. However, there are expenses you may incur that also add to the basis throughout the time you own the property. This additional basis can also reduce the amount of gain realized when the house is sold. For instance, the following items (this is not an all inclusive list) can increase the basis of property:

Capital improvements:

• Putting an addition on your home
• Replacing an entire roof
• Paving your driveway
• Installing central air conditioning
• Rewiring your home

Assessments for local improvements:

• Water connections
• Sidewalks
• Roads

Casualty losses: Restoring damaged property

• Zoning costs

Thus if you bought a house for $200,000 – your basis starts at that price. If you add an extra wing to the house in a couple years at a cost of $30,000, the cost of construction is added to your basis (now it's $230,000).

If a twister comes through and wipes out the roof on the addition and you restore the damage at $15,000, the basis increases to $245,000.

Now, you cannot take a double dip on an expense. For instance, Publication 551 says if you can deduct the expense from your current taxes, then you cannot add that cost to your basis.

Once you know your basis, then you can work on your gain. Gain is determined by subtracting the amount realized in the sale of your property minus the basis. This is not as simple as taking your gross proceeds and subtracting the basis amount. Uncle Sam actually lets a seller deduct selling expenses from the gross proceeds to determine amount realized.

Selling expenses include: commissions; advertising fees; legal fees; and loan charges paid by the seller, such as loan placement fees or "points."

Using the above house, if it now sells for $400,000, first you would subtract your basis ($400,000 - $245,000). Your initial gain is $155,000. Immediately, we see that you would not owe any capital gains if the house was your personal residence and you had lived in it for two of the last five years. Personal residence gain is not taxed until it tops $250,000 for single tax filers or $500,000 for married tax filers.

If it was an investment property, then this is your initial gain. Now we would subtract the selling costs.

Commission fees @ 6 percent:	$24,000
1 point paid for buyer on loan of $360,000:	$ 3,600
Estimated legal fees:	$1,000
Total cost of selling:	$28,600

The formula for determining reportable gain would look like this:

Net Gain:	$155,000
Cost of selling	$28,600
Net Capital Gains	$126,400

Now you're ready to calculate your capital gain tax based on your income level.

Remember that determining gain on an inherited property is different than for a home purchase. If you inherit a property the basis is calculated according to the fair market value of the property from the date you take title. If you received it as a result of a divorce, death of spouse, trade or other means of acquiring the property, then grab a copy of "Publication 523: Selling Your Home" and use the worksheet that starts on page 8 to calculate your new basis.

Next week, I'll take a look at the 2-year live-in requirement and how it affects your capital gains calculations.

Resources:

IRS Publications For Homeowners and Investors

523 Selling Your Home
527 Residential Rental Property
530 Tax Information for First-Time Homeowners
535 Business Expenses
551 Basis of Assets
936 Home Mortgage Interest Deduction