How Does the IRS Know Your Capital Gains on Real Estate?

Real estate remains an attractive investment vehicle because of its relative ease of understanding compared to stocks, bonds, and private companies and because of its myriad tax benefits. Among small investors, single-family houses and small apartment buildings are the most popular real estate purchased. These real estate types provide extensive tax benefits and a potential appreciation in value. In addition to the ability to deduct the expenses incurred, investors pay capital gains taxes on real estate when sold instead of the typically higher ordinary income tax.

Exclusion for Personal Residence

You do not have to pay any taxes -- capital gains or ordinary income -- when you sell your primary residence if your profit does not exceed $250,000 for singles or $500,000 for married individuals filing jointly. You will have to pay capital gains on any amount above that threshold. You can use this exclusion on the sale of your home only once every two years.

Capital Gains Calculation

When you sell a property, you report the gain on the sale – the capital gain – on Schedule C of your income taxes. It is your responsibility to determine this number. Your gain or loss is calculated as follows: The price you sold the property for minus any fees associated with selling the property minus your cost basis in the property minus fees associated with buying the property. What you paid for the property plus any upgrades, renovations or rehabilitations you made on the property provide your cost basis.

IRS Default Calculation

In the absence of calculating this information and providing it to the IRS, the IRS defaults to a simpler calculation to determine your cost basis and hence, your capital gain. The IRS default is to simply subtract what you paid for the property from what you sold the property for. If the IRS detects an error, it will review previous tax returns and compare what you included in the tax return that documents the sale with what you filed in the past. Hence it is important to keep good financial and property records for each rental property.

Capital Expenditures

In addition, keep a record of any capital expenditures made on the property. Capital expenditures include renovating a bathroom, building an addition, installing a deck or putting on a new roof. While you can deduct regular repairs and maintenance on Schedule C of your personal tax return, you cannot deduct these large, capital expenditures. Instead capital expenditures are added to the cost basis of the property -- in other words, capitalized -- and depreciated over time.

Purchase and Sale of Real Estate

When you buy a property, the settlement statement will delineate the purchase amount, any closing costs you incurred with the transaction and any mortgage financing you received. When you sell a property, the settlement statement provides the same information but focuses on the seller’s column. The statement provides the sales price, any loan payoff amount, and the closing costs you incurred and paid as the seller. Save both statements since you will use them to determine and justify your gain.