April Fool’s Day is the one day a year when it’s okay to play a friendly trick on a friend. Two weeks later is April 15, Tax Day, and not a good day to play tricks, especially on the IRS.
Most people use tax consultants to prepare their annual tax returns, which, in my opinion, is a very good idea. Tax preparers are schooled in looking for that deduction you may never have thought of; and if you sold your primary home in this tax year you will have a big deduction.
Since the late 1990s, homeowners have been allowed an exemption of up to $250,000 for single filers and $500,000 for joint filers on the profits on the sale of their principal residence. For example, a married couple who bought their home for $400,000 years ago and are now selling it for $850,000 should not owe tax on the sale because their $450,000 gain is covered by the $500,000 exemption.
In order to qualify for this benefit, the seller usually must live in the home for two of the five years preceding the sale. The property must also be the owner’s primary residence, with proof such as a driver’s license, receipt of mail, utility bills, etc. In addition, the capital gains exclusion can be used multiple times throughout your lifetime but generally only once every two years.
If your profit exceeds the $250,000 or $500,000 exemption based on filing status, the remainder of the profit is subject to capital gains tax. However, the law allows the owners of the property to lower their taxes by raising their “cost basis” if they have made capital improvements to the property, thus lowering their tax liability. Capital improvements include kitchen and bath renovations, landscaping, decking and other improvements made during the ownership period. There are other fees that can be deducted to lower your cost basis, including realtor fees related to the sale of the property.
Couples who have not filed a joint tax return prior to selling their home can still get the benefit of the deduction as long as they meet the IRS ownership and use test of two out of the last five years and file jointly for the year the home is sold.
In order to lower your cost basis and reduce your tax liability, you must be able to prove the capital improvements are legitimate. This involves good record keeping with receipts or credit card statements, but the way to be sure you’re counting every dollar is to consult a tax expert – or, if you’re in the mood, read the IRS statutes online.
There is one more way to reduce your cost basis and that’s a little-known law called “The Cohan Rule.” The Cohan Rule is a legal principle that allows taxpayers to use reasonable estimates to deduct expenses when they lack formal documentation, like receipts, to prove the expenses actually occurred. This rule originated in 1930 when the entertainer George M. Cohan brought a court case involving missing records.
Finally, I am not a CPA or a certified tax consultant. To get accurate advice, please consult one of these professionals.
Don’t play a trick on yourself before filing your tax return, especially if you sold your primary home last year. Ask for advice, save your receipts and don’t be foolish on April Fool’s Day.
