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May 15, 2008 02:21 PM

Homeowners avoid tax on $1 million capital gain.

Without records of improvements, IRS audit could bring trouble

May 15, 2008 02:21 PM

By Benny Kass
Inman News

DEAR BENNY: Friends of mine recently sold their home they owned for 22 years for $1.5 million; they paid about $500,000. They told me that they did not have to pay any capital gains tax, because their tax advisor claimed that they must have spent at least $1 million on improvements over the 20 years they owned it, although they did not have any records. He told them that it was within IRS guidelines, and their tax return was accepted without any problems.

Do you have any knowledge of those IRS guidelines? It is important for me because the existence of such guidelines will determine if I should sell my home or not. --Russ

DEAR RUSS: Hopefully, your friend did not get audited by the IRS. Although there may be an IRS ruling, I know of none.

A good source of information can be found in IRS Publication 523, entitled "Selling Your Home," which is available from the IRS Web site.

Basis is basically what you paid for your house. Adjusted basis adds any improvements that you made over the years. The best definition of an improvement is that which adds to the value of your home and prolongs its life. Publication 523 provides a number of examples: "adding a recreation room or another bathroom in your unfinished basement, putting up a new fence, putting in new plumbing or wiring. "

However, repainting your house inside or out, fixing your gutters or floors, or repairing broken windows are considered "repairs" and will not increase basis.

The IRS provides a caveat: Adjusted basis does not include the cost of improvements that are replaced and are no longer part of the home. For example, 15 years ago you installed wall-to-wall carpeting. Later you replaced that carpeting. While the cost of the new carpets is an "improvement," you cannot include the cost of the old carpeting.

If you have pictures of your house before and after you made improvements, you may be able to convince an IRS agent to allow some of the estimated cost as an improvement. But as far as I am concerned, if you do not have sufficient documentation, you will have an uphill fight should you be audited.