Capital gains tax based on original price or refi mortgage?

We live in Missouri, in the US, and purchased our first home for $43,000 in 1997. It was our primary residence for 3 years, during which we refinanced the mortgage for $50,000. After 3 years we turned it into a rental property and again refinanced as an investment property, this time for $60,000. After putting just over $20,000 in improvements into the property this year and last year we recently sold it for $78,000. My question is, are the capital gains taxes based on the original purchase price 10 years ago or on the amount of the mortgage we just paid off when we sold it?

Any financing amounts whether for the purchase or re-fi have nothing to do with the capital gains calculations.

The formula is Net Proceeds - Adjusted Basis = Gain.

Net Proceeds is fairly simple -- whatever you sold it for less any selling expenses such as commissions and non-recurring closing costs. So, if you paid a 6% commission ($4,680) and $1,000 in closing costs, your net proceeds would be $72,320.

Adjusted Basis is where it gets tricky, especially as you rented out the property. You start with the purchase price -- $43k in your case. Then you add any improvements, $20k in your case for a total investment of $63k. Now you must subtract any depreciation allowed OR ALLOWABLE while you held the property as an investment. That "OR ALLOWBLE" can get you since you must adjust for depreciation even if you didn't take a depreciation expense deduction while renting it out. So, for sake of argument you took a total of $9,500 in depreciation deductions over the years (an amount that I could justify, by the way, if I were an IRS auditor) then you subtract that from your total investment of $63k to arrive at an adjusted basis of $53,500.

Subtract your Adjusted basis of $53,500 from the net proceeds of $72,320 and you get a taxable gain of $18,820. Since you don't qualify to exclude the gain from the sale you'll pay capital gains tax on the entire amount. But since you held it for over 1 year, the gain is taxed at the long term rate, normally 15%. However if your tax bracket is already 15% or lower, the rate is 5%. Assuming that your tax bracket is higher than 15%, the total tax due from the sale would be $2,823.

Original purchase price + cost of improvements less any depreciation

so 63,000 is your basis less depreciation, capital gain is at least $15,000

From http://www.irs.gov

Basis of Property Changed to Rental Use
When you change property you held for personal use to rental use (for example, you rent your former home), you figure the basis for depreciation using the lesser of fair market value or adjusted basis.

Fair market value. This is the price at which the property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts.

Capital gains are based on original purchase price, plus costs of buying it originally, plus costs incurred on the mortgages that were not deductible at time of taking out the mortgage, plus costs of any improvements you put into the home, less depreciation taken when it became a rental home, plus costs incurred on selling the property. This is your cost basis now, which you would subtract from the sale price of $78,000 to arrive at capital gain. Since you owned it since 1997 your gain will be long-term gain, and will be taxed at maximum of 15% (5% if you are in either the 10% or 15% brackets). State tax will be long-term and will be at your state rate.

10.1 Capital Gains, Losses/Sale of Home: Property (Basis, Sale of Home, etc.)

I lived in a home as my principal residence for the first 2 of the last 5 years. For the last 3 years, the home was a rental property before selling it. Can I still avoid the capital gains tax and, if so, how should I deal with the depreciation I took while it was rented out?

If, during the 5-year period ending on the date of sale, you owned the home for at least 2 years and lived in it as your main home for at least 2 years, you can exclude up to the maximum dollar limit. However, you cannot exclude the portion of the gain equal to depreciation allowed or allowable for periods after May 6, 1997. This gain is reported on Form 4797 (PDF),Sale of Business Property. Refer to Publication 523, Selling Your Home, and Form 4797 (PDF), Sale of Business Property, for specifics on calculating and reporting the amount of gain.

I've attached a couple links to irs info for you to look over.

The amount of the mortgage on your property has nothing to do with the capital gains. The original purchase price figures into the basis for capital gains but there are depreciation and improvements that figure into it as well.

Although you originally lived in this property, you are not eligible for the primary residence exclusion. Your property is a business property.

The basis for depreciation of your property is the lower of the market value at the time you placed your property into service, or the original cost of the property. From your information, your basis at the time of conversion was $43,000. You were allowed to depreciate this basis over the time you rented it. It isn't clear when you converted it, but I'm guessing that was in the year 2000, so you have 7 years of depreciation, or in the neighborhood of $10,000. You then added $20,000 of improvements. So very roughly your basis for capital gains is

$43,000 - depreciation + improvements = $53,000.
Capital Gains: $78,000 - $53,000 = $25,000

You report the sale of your property on Form 4797, and the capital gains is then transferred to Schedule D.

Have someone review your records to see that you are paying the least possible. Your gains will also be affected by transaction costs of buying and selling the property.