|EXECUTIVE SUMMARY |
| As home prices escalate and the IRC gain exclusion remains stationary, the potential for taxable gains looms ever larger. It’s important to know the tax basis in your home and keep accurate records.
The initial tax basis includes the cost of the home plus all settlement and closing costs.
Home improvements— such as construction of an addition or installation of a pool—give rise to basis increases.
Deductible casualty losses; payments received for granting an easement; and residential energy and first-time homebuyer credits may result in taxpayers’ reducing the tax basis in their homes. Homeowners who use their homes for business or rental use and who depreciate a portion of their home also must reduce basis accordingly.
Generally, keep tax returns, worksheets and forms for three years. Keep any records relating to property longer, as they are relevant for determining basis.
Leonard Goodman, CPA, PhD, is professor of accounting at Rutgers University, New Brunswick, N.J. His e-mail address is email@example.com . Jay A. Soled, JD, LLM, is an associate professor of taxation at Rutgers University in Newark, N.J. His e-mail address is firstname.lastname@example.org .
ome prices have skyrocketed over the past few years, but the exclusion afforded to taxpayers by IRC section 121 has not kept pace with the surge. This part of the tax code excludes the first $250,000 ($500,000 in the case of joint filers) of home sale gain from tax if certain conditions are met. But Congress did not index these exclusion figures for inflation.
According to the National Association of Realtors ( www.realtor.org ), the median U.S. home price jumped to $218,000 in October 2005, up 16.6% over 2004 and 55% over 2000.
As home prices escalate and the IRC section 121 exclusion remains stationary, the potential for taxable gain looms ever larger. This article thus explores the general tax rules associated with home ownership and suggests ways taxpayers can minimize their gains when selling their homes.
In general, taxpayers recognize all gains on the sale of property, including homes. Because a home does not fall within any of the exceptions to capital asset classification, any gain arising from a sale is subject to preferential capital gain rates. To promote home ownership and in recognition of the difficulties of ascertaining a home’s tax basis, Congress has traditionally offered homeowners numerous tax benefits.
Under current law, taxpayers can exclude from income the first $250,000, or $500,000 in the case of joint filers, of gain on the sale or disposition of a personal residence. For this exclusion to apply, however, two conditions must be met. First, the property must be the taxpayer’s principal residence (that is, the property the taxpayer occupies the majority of the time). Second, the taxpayer must have owned and used the property as a personal residence for two or more years of the five-year period ending on the date of the sale of the property.
The exclusion of the gain from income under IRC section 121 is not a one-time offer. Taxpayers can use it every two years, as long as they’ve met both the required conditions. If a taxpayer has experienced a change of employment or health or when certain other unforeseen circumstances arise (for example, involuntary conversion of the residence), this two-year limitation rule is relaxed under IRC section 121(c)(2).
Even a cursory reading of IRC section 121 reveals that when Congress instituted it, the intent was to exclude the vast majority of personal residence gains from tax. But even a decade ago, Congress did not anticipate how quickly home prices would escalate. Now, with a federal budget awash in deficits, there is little discussion in Washington about raising the IRC section 121 exclusion figures or indexing them for inflation (though President Bush’s Blue Ribbon Tax Reform Panel recently recommended raising the exclusion to $300,000 for single taxpayers and $600,000 for married ones filing jointly). Thus, it is more important than ever for taxpayers to accurately track the tax basis in their homes.
Like any other investment a taxpayer makes, a personal residence has an initial tax basis that fluctuates over time. First, let’s examine the computation of the initial tax basis; then we’ll explore the nature of adjustments to this basis.
Initial tax basis. The usual supposition under IRC section 1012 is that cost represents the taxpayer’s initial tax basis. If the taxpayer rolled over a prior home-sale gain under pre-1997 law, the taxpayer’s initial cost basis must be reduced by this unrecognized gain.
Other items also factor into the initial tax basis—including all settlement and closing costs (Treasury regulations section 1.212-1(k)). IRS Publication 523, Selling Your Home, offers the following examples of such costs: abstract fees; charges for installing utility lines; legal fees (including fees for the title search and preparing the sale contract and deed); recording fees; survey fees; transfer taxes; owner’s title insurance; and any amounts the seller owes that the buyers agree to pay, such as certain real estate taxes, back interest, recording or mortgage fees, charges for improvements or repairs, or sales commissions.
Personal living expenses are not included. IRS Publication 523 cites the following items related to settlement and closing costs as personal living expenses that are not added to the basis: fire insurance premiums, rent for occupancy of the house before closing, charges for utilities or other services related to occupancy of the house before closing, any fee or cost that a taxpayer deducts as a moving expense, charges connected with getting a mortgage loan and fees for refinancing a mortgage.
Special basis rules apply if a taxpayer receives a personal residence as a gift, bequest or payment for services rendered. In the case of a gift, the taxpayer’s basis in the house generally is equal to the donor’s basis (IRC section 1015(a)). In the case of bequests, the basis generally is equal to the fair market value at the date of the decedent’s death (IRC section 1014(a)). And in the case of compensatory transfers, the basis is generally equal to the fair market value on the date of transfer (Treasury regulations section 1012-1(a)).
Adjustments to basis. Some expenditures and circumstances are nonevents for tax purposes and some will give rise to basis adjustments. The cost of repairs that maintain the good condition of a home but do not add to its value or prolong its life—such as exterior and interior painting, blacktop sealing or chimney cleaning—do not get added to the tax basis. Home improvements, such as construction of an addition or installation of a pool, do increase the tax basis (IRC section 1016(a)).
Several circumstances may cause homeowners to reduce the tax basis they have in their homes, including deductible casualty losses (or insurance payments related thereto); payments received for granting an easement or right-of-way; and residential energy, adoption and first-time homebuyer credits. Taxpayers who use their homes for business or rental and who depreciate a portion of their homes also must reduce the tax basis accordingly. Finally, taxpayers who remove improvements from their homes must reduce the tax basis by the basis they had in these improvements (see, for example, Bayly v. Commissioner , TC Memo 1981-549).
To illustrate the mechanics of computing a tax basis, let’s consider the example of Jay and Kay. In 1998 they purchased a house for $300,000 and incurred $20,000 in closing costs. In 1999, they built a three-room addition to the house for $30,000; in 2000, they had the house painted for $5,000; in 2001, they were paid $50,000 for a conservation easement going over a portion of their land; and in 2002, they razed one of the three rooms they had built in 1999. Finally, in 2005, Jay and Kay sold the house for $900,000.
Here’s how they would compute their tax basis:
|Initial Cost Basis
|Cost of three-room addition
|Removal of one room
|New Adjusted Basis
Since their current basis in the home is $290,000, Jay and Kay would realize a $610,000 gain ($900,000 – $290,000). After accounting for the $500,000 exclusion under IRC section 121, the couple would owe capital gains tax on the remaining $110,000 of gain ($610,000 – $500,000).
The government has made clear the importance it attaches to basis records. The Internal Revenue Code imposes an obligation on taxpayers to “keep such records as the Secretary of the Treasury may from time to time prescribe,” and the relevant Treasury regulations echo this sentiment. The instructions to form 1040, under “How Long Should Records Be Kept?” in the “General Information” section, state that “tax returns, worksheets and forms should be kept for three years, but records relating to property should be kept longer insofar as they are relevant for determining basis.” IRS Publication 552, Recordkeeping for Individuals, also says “everybody should keep” basis records for their homes.
Taxpayers should retain proof of their home’s purchase price and other records that document the costs of improvements, additions and other items affecting the home’s adjusted basis not just for three years (the traditional retention period for tax records), but rather for the entire span of home ownership plus an additional three years from the point of sale. While tax returns generally need to be retained for only three years, it is prudent to hold onto returns for which a form 2119—related to tax-free rollovers under prior law—was filed because this form shows any postponed gain on residence sales made before May 7, 1997. In case of an audit, producing originals or photocopies of these salient documents can prove invaluable.
What are the tax consequences of failing to keep good records? Some taxpayers believe that absent written documentation tax basis is deemed to be zero, but this is not exactly correct. The governing rule, having its genesis in the frequently cited Cohan v. Commissioner decision, essentially is that taxpayers can make offers of proof relating to the issue of basis, but the courts are at liberty to construe the proffered evidence in the light least favorable to the taxpayer.
Several courts have applied the so-called Cohan rule. In some cases taxpayers offered only their own oral recollections and rough estimates (see Bayly v. Commissioner ); in others they had some corroborating evidence such as bills and documentation relating to mortgage loans (see Cenedella v. Commissioner ); and in still others, they were able to show before and after improvement photographs of their homes (see Estate of Gunther v. Commissioner ). In each of these cases, the courts relied heavily upon the Cohan rule; that is, they granted taxpayers some leeway in proving the tax basis in their homes but gave virtually all benefits of the doubt to the government.
There is a simple axiom in the income tax system: For every extra dollar of tax basis an asset has, there is one less dollar of gain to recognize or one more dollar of tax loss to report. While the tax-loss side of this equation does not apply in the context of home sales, due to the disallowance rule for transactions that are not entered into for profit, the minimization-of-gain aspect has tremendous relevance. Every time taxpayers make purchases related to their homes, prudence requires they bifurcate such outlays as either expenses or improvements. Taxpayers should keep careful records of the latter category to minimize their gains.
Taxpayers also should pay particular attention to four key strategies.
IRC section 121 can be capitalized upon every two years. So rather than retaining title to their homes over several decades, taxpayers should consider selling their homes every few years and using IRC section 121 to shield their potential gains. Holding a home over a shorter period of time lessens the prospects that its appreciation will exceed the current IRC section 121 thresholds, even if home prices increase rapidly.
Elderly taxpayers should think twice before gifting their homes. Many do this as a form of Medicaid planning (that is, to divest themselves of assets in order to qualify for Medicaid). There are two flaws in this approach. First, recipients who receive title to the property in question also receive the taxpayers’ basis in such property, which is usually quite low. Second, when title to the home is then sold, the taxpayers who received this gift often do not qualify for IRC section 121 relief because they don’t meet the two-year personal use requirement. The result is usually large—and unexpected—taxable gains. Had the elderly taxpayers retained title to the home in their names, could have eliminated the gains largely via the basis-equals-fair-market rule applicable upon death (see IRC section 1014(a)).
Taxpayers who own both a personal residence and a vacation home should carefully consider their strategy for selling these properties. If the ownership of their personal residence meets the qualifications of IRC section 121, they should sell their personal residence first and command the benefit of the IRC section 121 exclusion. Then they should make their vacation home their primary residence and live there for two years. Once they have met this residency requirement, they can sell their erstwhile vacation home and once again take advantage of the IRC section 121 exclusion.
Sometimes taxpayers exchange property that satisfies the requirements for both the exclusion of gain for a primary residence under IRC section 121 and the nonrecognition of gain on the exchange of like-kind properties under IRC section 1031. This may happen in one of the following contexts: when taxpayers meet the ownership and residency requirements of IRC section 121 and subsequently rent the same property as part of a trade or business or when taxpayers use part of the property as their personal residence and another part of it in a trade or business, say as a home office.
| Be sure clients keep a journal of their home purchases, closing expenses and record adjustments and all related receipts and records.
Consider capitalizing on IRC section 121 by selling your personal residence every two years.
Advise elderly clients to think twice before gifting their homes.
Revenue procedure 2005-14 explains the implications when such mixed-use property is exchanged for like-kind property, generally allowing taxpayers to simultaneously capitalize on the exclusion IRC section 121 affords and the deferral offered by IRC section 1031.
Let’s consider a simple example in which Mary, an unmarried taxpayer, buys a house for $210,000 and uses it as her principal residence from years one to five. From years five to seven, she rents the property to a tenant and claims depreciation deductions of $20,000. The house qualifies as a personal residence under IRC section 121 and as trade or business property under IRC section 1031(a). The house has an adjusted basis of $190,000 ($210,000 – $20,000).
If Mary exchanges the house for $10,000 of cash and a townhouse with a fair market value of $460,000 that she intends to rent to tenants, she realizes $470,000 on the exchange (that is, $10,000 cash plus the fair market value of the townhouse). After subtracting the $190,000 adjusted basis in the house from the realized gain, Mary recognizes a $280,000 gain ($470,000 – $190,000). She can exclude $250,000 of the gain recognized under IRC section 121 and defer the remaining $30,000 of gain recognized under IRC section 1031. Her basis in the replacement property is $430,000: the basis of the relinquished property at the time of the exchange ($190,000) increased by the gain excluded under IRC section 121 ($250,000) and reduced by the cash she received ($10,000). Revenue procedure 2005-14 offers several other more complex examples detailing the benefits and the interplay IRC sections 121 and 1031 offer.
When it comes to the tax basis in one’s home, taxpayers have many arrows in their tax-planning quivers. They must be careful, however, to aim carefully at the intended target: a reduction of their capital gain income.
2005 Individual Tax Returns videocourse (DVD/text/manual, # 113606JA; VHS/text/manual, # 113607JA).
IRS Publication 523, Selling Your Home. www.irs.gov .
IRS Publication 552, Recordkeeping for Individuals. www.irs.gov .