If the IRS Comes Calling About a Deduction, You'll Want Proof

By Benny L. Kass
Saturday, January 31, 2009

Last in a series of articles

"The art of taxation consists in so plucking the goose as to

Obtain the largest possible amount of feathers with the

Smallest possible amount of hissing."

-- Jean Baptiste Colbert (1619-83)

As you pull together your records to get ready for this year's April 15 tax filing deadline, you should also be thinking about which paperwork you need to keep for the longer term.

There are record-keeping guidelines that apply to all taxpayers, and some of special interest to homeowners.

IRS regulations require taxpayers to "keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits or other matters required to be shown by such person in any return of such tax or information."

On its Web site, the tax agency points out that there is no "special manner" in which you are required to keep records. It goes on to say, "Generally speaking, however, you should keep any and all documents that may have an impact on your federal tax return." That includes "bills, credit cards and other records, invoices, mileage logs, cancelled, imaged or substitute checks or any other proof of payment," and "any other records to support deductions or credits you claim on your return."

These records must be retained for as long as they may be -- or might become -- "material" for any federal tax purpose. What does "material" mean? Generally, the IRS can audit and challenge your tax return until three years after your return was due or filed or two years after the tax was paid.

However, there are many exceptions. For example, if it is determined that you have underpaid your tax by more than 25 percent, then the IRS has six years in which to take action against you. Additionally, criminal prosecutions involving such matters as fraud, failure to file a tax return or filing a false statement can be brought at any time.

There are some things for which homeowners should keep records for a lot longer than a few years. Those are the forms and receipts that document what you pay to buy, sell and improve your home. That's the case even if you're not buying or selling in a particular tax year.

One of the biggest tax benefits available to homeowners is the ability to avoid paying taxes on some or all of the profit from the sale of a house. You can exclude from taxation your capital gain up to $500,000 (for married couple filing jointly) or $250,000 (for single filers or a married person filing separately). Keeping good records of the work you do on the house will help you take the maximum advantage of this tax break.

To calculate your gain, you subtract selling expenses such as real estate commission from the selling price. The resulting figure is called the "amount realized."

Then from the amount realized, you subtract what is called your "adjusted basis." The adjusted basis is what you paid for the house, plus the cost of improvements and some other, less common, costs. The result is your gain.

Here's how that works. Say you paid $300,000 for your home years ago, and expect to sell it and bring in $800,000 after commissions and other selling costs. Your gain is $500,000. If you are married and file a joint tax return, you are home free. You can exclude up to $500,000 of your gain.

But if you are single, you can exclude only $250,000 of that profit. So let's say that over the years you have made significant changes to the house -- added a new room or updated your kitchen. The costs associated with these improvements are all added into your tax basis. (The IRS does not count maintenance and repairs as an improvement. So while adding built-in appliances is an improvement, painting is not.)

In our example, if you can prove that you added $100,000 in improvements to your house, your adjusted tax basis becomes $400,000 instead of $300,000. Your profit falls to $400,000 ($800,000 minus $400,000). You would owe capital gains tax only on the amount above the $250,000 exclusion, which would come to $150,000.

The current federal capital gains tax rate is 15 percent, so the improvements to your house would save you $15,000 in federal tax, as well as any applicable state or local taxes.

So, for as long as you own the house, keep copies of any construction or renovation contracts, invoices for supplies and materials, and copies of canceled checks or your bank statements showing payments.

People who bought and sold homes before 1997, when the capital gains exclusion rules went into effect, need to take those earlier transactions into account when determining their basis. Many of these homeowners deferred taxes on those sales, which affected their basis at the time. The IRS recommends that you keep records that support how that basis was figured, too. Realistically, that means keeping records that go back to the purchase of your first home.

For more information on the tax consequences of a home sales, see IRS Publication 523, "Selling Your Home."

For general information on recordkeeping, see IRS Publication 552, "Recordkeeping for Individuals."

Both publications are available on the IRS Web site, http://www.irs.gov. You can also call the IRS at 800-TAXFORM to order forms, instructions and publications. Between now and April 15, many public libraries also provide tax information; check with your local librarian.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.

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