Is Downsizing in Your Best Interest?

Everyone thinks of downsizing once they are empty nesters or many homeowners just might want a change.  Downsizing your home does have many financial advantages as well as less upkeep but is it the best way to go when it comes to taxes?  When you downsize more than likely you will end up with cash from the sale of your larger home which could end up adding to a big tax bill. 
Currently if you sell your home (principal residence) for a profit, you could qualify to  knock off $250,000 ($500,000 for married filing jointly) of your capital gain.  In order for you to benefit from the maximum exclusion you will need to pass the ownership and use test by the IRS.  The IRS will want to make sure you have owned the home for the last two years and that you have lived in the home as your principal residence for the past two years (ending on the date of the sale).
The IRS does have exceptions to the rules when it comes to the ownership and use test.  For example, if you are moving before owning the home for two years because of a job change (seen as unforeseen circumstances) it is exempt.  Other unforeseen circumstances the IRS has are divorce or natural disaster.  In circumstances such as these, the IRS will allow the homeowner to prorate the exclusion.
A homeowner does not have to live in the home for two consecutive years just as long as a homeowner has lived in the home 24 months out of the five years prior to the sale of the home.  Also, you can only claim and exclusion once every two years.
Before you decide to sell your home, you will want to calculate your cost basis.  Do this by figuring out the capital gains on the sale of your home then subtract your cost basis from the selling price.  Your cost basis includes the purchase price along with settlement fees, closing costs and commissions associated with both the purchase and the sale. Take these and add to the cost of all the improvements you have done to the home which will be your cost basis.
Determining if something is a capital improvement or repair is also important because capital improvement can be added to your cost basis but repair cost cannot.  Why?  A capital improvement will increase the value of your home, while a repair will just restore your home to its original condition.  For example, a new deck is a capital improvement while fixing your plumbing is considered a repair.  A new roof would be a capital improvement however, just replacing a  few shingles is just a repair.
If you are looking to downsize, you may want to consider whether to buy or rent.  Renting will release you from all the obligations of owning a home but you will not be building equity and you will have to answer to a landlord.  There is no right or wrong answer, it is a personal preference which is right for you.