I think most people know that when you sell a house, you can designate it as your principal residence and thereby avoid a taxable capital gain.
What about if you buy vacant land and build a house on it? Well, if there was no house on the land for one or two or ten years, the property can't be designated your principal residence for those years. So if you owned the land for 10 years and lived in a house you built for 8, only 8 of the 10 years will be exempt from capital gains. You might think, fine, there wouldn't be much change in the value of vacant land over two years, so no big deal. But that's not how it works.
You buy vacant land for $10,000. A couple years later you build a house on it and settle in. Your property assessment that year says the land is worth $9000, but you could probably sell it for $11,000. The next year your assessment goes up to $200,000 since there's now a house on it. Eight years after that you sell the property for $500,000.
You only pay tax on 50% of that so
490,000/2=245,000 taxable gain
And you can designate it as your principal residence for 8 years so
245,000/10*8=196,000 tax exempt portion
So that leaves a taxable gain of $49,000.
Yup. Even though in the two years you weren't living there the value barely changed, for some reason you're paying tax on $49,000. Part of the value of the house is being attributed to years there was no house on the land. To me this seems like major discrimination against people who build their own houses. Principal residence is supposed to be tax exempt, but in this situation you'd end up paying tax on part of it, unlike someone who bought an already built house.
Luckily, you can mitigate this by claiming the expense of building the house, legal fees, realtor commission, etc., which you wouldn't normally be able to do when selling a fully tax exempt principal residence. But you have to know about it beforehand.
So that's the tip/warning. Keep track of all your expenses and keep receipts forever. Scan or photograph as much as you can, especially the receipts on heat sensitive paper.
This year at work, I had to help a few people in this situation. None of them had any clue that there would be a capital gain because they hadn't always lived on the property, and none of them had any record of any expenses.
Building materials are so expensive right now that I bet a lot of people who have recently or are planning to buy land may decide to wait a year or two before building. So this advice/warning is quite timely.
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