Tax tips for homeowners.
What do a live oak tree, a new water heater, and a fence have in common? Know what a “fixing up” expense is, and why it’s important? If you own a home, you need to know the answers to these questions, because some day the I.R.S. will be quizzing you about them. These are two of the key factors in determining how much capital gains tax you will have to pay, if any, when you sell your house.
Don’t flip that page. Just because you’re not currently in the process of selling doesn’t make the subject any less important. The average home owner moves every five to seven years, but even if you never move, your heirs will appreciate a few records. And forget the three-year “rule of thumb” for keeping tax records. You need to keep these records virtually forever.
First, the good news: Tax on all or part of the profit you make on the sale of your house may be deferred, in some cases indefinitely. You don’t have to pay tax at the time of sale if within 18 months before or 18 months after the sale you buy and occupy another residence which costs as much as or more than the old residence. (We’ll discuss later what we mean by “cost.”) Then, as long as you keep “buying up” – that is. paying more for succeeding houses – you can continue to avoid a capital gains tax on your profits. And paying more for new houses, as you may have observed, is difficult to avoid.
But what about that unlucky soul who sells his old house for $100,000 and finds a dream cottage in Richardson for $95,000? Suppose he paid only $40,000 for the old place. Is he stuck with a tax bill for the $60,000 profit? Fortunately, no. He only has to pay a capital gains tax now on the difference between the sale price of the old house and the lesser cost of the new one, or in our example, $5,000. Tax on the other $35,000 is deferred in exactly the same manner as in the case where the new house cost more than the proceeds of the old one.
The tax deferral in either situation is mandatory, not optional. So don’t try to play games by biting the tax bullet voluntarily to offset losses from other endeavors. There is, of course, some flexibility. You don’t have to buy and occupy another residence within the qualifying 18-month time limit. And don’t lose sight of the fact that the tax is postponed, not forgotten. Remember the fellow who bought the $95,000 house in Richardson and in the process postponed tax on $35,000 of the profit he made from the sale of his old house? Well, he has to subtract the $35,000 from the cost of the Richardson house, making his basis only $60,000. So if he sells the Richardson house later on and moves to an apartment, he has to pay a capital gains tax on the excess over $60,000 which he derives from the sale. So you can see the importance of continuing to play the game once you begin it. (By the way, if you have the misfortune of selling a house at a loss, the amount of loss is not deductible.)
Now let’s get into the specifics of determining costs. The cost of your old house (or the “adjusted basis,” as the , I.R.S. calls it), is the amount you paid for the house plus the cost of improvements and additions you made to it. So even if you don’t expect to sell your house for 40 years, you need to retain complete records to substantiate all such sums. Receipts, not remembrances. The I.R.S. has not yet adopted the “cross my heart and hope to die” method of proving expenditures.
Repairs are not considered in determining the adjusted basis. Painting is a repair, for example, and so is fixing a leaking faucet. A new roof is a capital improvement, however, as is a new fence, furnace, or air conditioner. All can therefore be included in the adjusted basis. Additions are the costs that are most easily substantiated as capital improvements.
Keep good records on the “start up” costs of your new house: the first drapes, the first grass, the first trees. These are considered capital improvements, although their replacements may not be. In any case, save those receipts. Without them you can’t even argue.
Even repairs figure into your calculations when they qualify as “fixing up expenses.” This rather uncharacteristic colloquialism is used by the I.R.S. to describe repair expenses incurred no more than 90 days before you sign the contract to sell your house. But let’s stop, take a deep breath, and see how all of this might actually work out:
If you don’t buy another house within 18 months, stop here. You will pay capital gain taxes on the $20,000. But you] probably don’t want to do that, so let’s go on:
Note with caution that the fixing up expenses are not considered in calculating the amount of profit you made on the sale of your old house. In fact, in our example they are of no consequence at all, because the $80,000 cost of the new house easily qualifies you for tax postponement since it exceeds the amount realized on the sale of your old home by $10,000. But if your new house had cost only $69,000, you would need the fixing up expenses to qualify you for full postponement.
If you build your own replacement house, the 18-month rule for purchasing still applies, but you have 24 months in which to occupy. The same is true if you contract to have a residence constructed according to your specifications on a specified lot. But you don’t get the extra time to occupy if you contract to purchase, when completed, a house which a builder has already started.
Don’t try to double dip. Some of your selling expenses, such as real estate commissions, may be deductible from your income tax as moving expenses. If you take such a deduction, you can’t include the same item in your capital gains calculations.
Sure, this is all a big bother. But don’t fight it. Get a big box, mark “House” on it, and pitch in a receipt for every expense which you incur for improvements. From now on.
You Play the Game, They Make the Rules.
The IRS publishes guides that make computing tax bases easy – well, easy if you’re a CPA with an advanced degree in economics. But if you want to try to figure them out, the guides of particular interest to homeowners are publications 523, Tax Information on Selling or Purchasing Your Home, and 551, Tax Information on Cost or Other Basis of Assets. Available free at the Internal Revenue Service Office, or by writing the Superintendent of Documents, U.S. Government Printing Office. Washington, D.C. 20402.
Tax tips for homeowners.