Q: We have been living in our house for over 30 years. With our grown children no longer living with us, we have reluctantly decided to sell and move to a smaller place. We bought the house for $150,000, and now we think it can sell for over $800,000. But we don’t want to pay a lot of taxes, since the sales proceeds will be used for our lifestyle. We were told that we may have to pay capital gains tax on the $650,000 profit. Any suggestions?
A: It appears that you were given bad advice. The law is very clear: If you have owned and lived in the property for at least two of the five years prior to selling and file a joint income tax return, you can exclude up to $500,000 of any profit (or up to $250,000 if you file a single return). This is known as the use and occupancy test.
So you bought the property for $150,000 and will sell it for $800,000. Your gross profit is $650,000. You can exclude the first $500,000, and thus your capital gain has been reduced to $150,000.
Did you notice that I used the term gross profit? Did you make major improvements to the house in the many years you have been living there? For example, did you add a new room to the house? Did you improve and renovate the kitchen or the bathrooms?
Your basis for tax purposes is what you paid for the house, namely $150,000. But any major improvements increase that basis. For example, if you paid $150,000 over the years for these improvements, your basis is $300,000. Subtract that from $800,000 and your gain is $500,000. You do not have to pay any federal capital gains tax.
You say you do not have any proof of these improvements. Shame on you, but you are still in luck. Do you remember George M. Cohan and his “I’m a Yankee Doodle Dandy” song? Well, Mr. Cohan was audited by the Internal Revenue Service but did not have written receipts to prove his business expenses. The IRS denied his deductions. But George went to court, and the IRS lost.
Judge Learned Hand wrote back in 1930 that just because there were no receipts “it is not fatal that the result will inevitably be speculative; many important decisions must be such.”
In other words, if you can prove with photos or affidavits, for example, that you made additions to your house, the law allows you to use estimates. Keep in mind, however, that despite the so-called “Cohan Rule,” the IRS will challenge your deductions.
The moral of this story is to keep records for as long as you own your principal residence, plus three years. For more information, see IRS Publication 523, “Selling Your Home,” available from irs.gov.
Q: My 90-year-old mother has a house without a mortgage. In her will, this property will be mine, but since I have a house I suggest she sell her house to my son. The house is valued at $180,000, but I recommend she sell it for $160,000.
He will have to get a mortgage from a bank, and she will have to live in this house to the day she dies. Do you see any problem with this plan? Any taxes and so on?
A: Not only do I not see problems, I like the idea. Assuming that your son can get a mortgage, your plan makes a lot of sense.
In fact, assuming your mother is coherent and can make decisions, she might want to take back the financing (instead of having your son find a mortgage lender).
Your mother can include in her last will and testament that on her death, she waives any outstanding balance that your son may owe.
You or preferably your son should consult with local counsel to explore this idea. I cannot provide specific legal or financial tax advice.