A few weeks ago we were contacted by a new client; a widower in his nineties. He had not filed a tax return in over twenty years. He was not required to file. His pension and taxable Social Security income never exceeded his standard deduction and personal exemption which is often the case with elderly retired people.
This gentleman had recently sold the home which he and his late wife bought in 1967. He was worried that he owed a significant sum of tax from the sale and asked some very good friends of his to recommend a tax professional. James L. Hayes MBA & Co., Inc. was very highly recommended. When he first called me I asked a few questions to get an idea of his circumstances. We made an appointment and among the papers I asked him to bring were the closing documents from the sale of his house and if he still had them, the closing documents from the purchase of the house. He quickly replied that he still has all of those. I also asked for any receipts or invoices he may still have for improvements made to the home during the time he and his late wife owned the hose. When this new client arrived at my office with a big folder of paper I was pleasantly surprised to learn that there are still people who keep all of the important documents. He gave me something to work with. I am an accountant after all, not a magician. During my initial consultation I learned a bit more about this man and his late wife who died in the early eighties. At first it seemed that he might owe a capital gain tax on the sale of his home but I promised we would do our best to minimize the tax impact of selling his home of fifty years.
We sorted through fifty years worth of bills for repairs and improvements made to the house in mid Westchester. Everything was arranged in chronological order. Small repairs were placed in a separate pile. Our goal was to Compute this man's basis in his former home. Basis is the owner's investment in a property. Basis begins with the purchase price and is increased by the cost capital improvements made. Capital improvements are those which substantially improve a property's usefulness or extend its useful life. Repairs such as replacement of a leaky faucet of patching a hole in the roof are not capital improvements. Basis in a property is reduced by depreciation claimed or debt forgiven since this man never used the property for business and honored his debts neither of those applied. We began by scheduling his basis beginning with the purchase price of $19,500 plus closing costs. Yes. $19,500 for a house in mid Westchester in 1967. We added the cost of a deck built in 1974, an addition built in 1975 and an in-ground pool built in 1979.
When this man's wife died in the early 1980s he inherited her half of the home. When property is inherited the heir's basis in the property is the Fair Market Value at the time of death or the Alternate Valuation Date. Most often inherited property has a fair market value greater that the decedent's basis. In tax accounting parlance this is called a step up in basis. No estate tax return was filed when the late wife died. In the year she died the Estate Tax Exclusion was $325,000. Her gross estate was far less than that not to mention that the Marital Exclusion with regards to estate tax is unlimited.
We then added the cost of a solar hot water system installed in 1985, a new driveway in 1990, complete replacement of the home's plumbing in 1993, upgraded electrical service and panel in 1999, a new roof in 2006, new windows in 2009 and a new high efficiency boiler in 2012. Remember that deck that was built in 1974? It was done without a building permit. To sell the house our client first had to make that deck legal. The building permit alone in 2016 cost more than the deck did in 1974, the architect hired to examine the deck and design changes needed to make the deck compliant with current building codes together with the contractor who did the work cost almost as much as the addition built in 1975. While the work done in this instance amounts to minor repairs the seller could not have sold the house without having first made these modifications. That makes this a capital improvement. The next step was to find out what the proceeds on the sale of the home in late 2016 were. We start with the sale price from the closing documents which matched the amount reported on form 1099-S. From that we subtracted the attorney's fee, New York Real Property Transfer Tax and realtors’ commissions which was more than he paid for the house almost fifty years earlier to compute the net proceeds from the sale. We subtracted the basis from the net proceeds and arrived at the total gain on the sale of the home. The Internal Revenue Code contains a provision (Section 121) to exclude $250,000 of gain ($500,000 if married filing jointly) from taxable gains. Even after the section 121 exclusion there was still a small gain but...the gain was not enough to cause enough Social Security income to become taxable and the long-term capital gains tax rate in this case was 0%.
Even with a significant gain on the sale of his property this client owes no tax to either the IRS or New York State. We prepared and filed tax returns to prove it.
There are a couple of important lessons to take away from this case.
Keep all important papers! How do you know which papers are important? If the expense was big enough to seek competing proposals or if the expense was something you had to discuss with your spouse than it is important.
Comply with all regulations!
While building permits and the permitting process turn a small weekend project into a major project the cost is cheaper in the long run.
IRS CIRCULAR 230 DISCLOSURE: Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this website (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.