Late last year a client asked me for a copy of the final settlement statement (aka Final HUD) from when he purchased a house in 2004. Unfortunately, I no longer had a hard or soft copy of this document due to several computer changes, at least one hard disc drive crash and the annual clean out of hard copy files older than 7 years. I checked with the title company and they no longer had the records. I even tried asking the seller but she had just shredded the documents related to the sale a few months before. Luckily a couple months later when I was cleaning out old hard copy files I discovered a box labeled 2004 but it looked like a 2009 so it had never been discarded. (Sometimes my horrible handwriting comes in handy.) Though I did not have the official final HUD I did have a hard copy of the preliminary HUD from the day before close. This was probably close enough for the client who needed this document for his tax return.
Why was the owner so desperate to find the settlement statement? This was because he, like many other buyers during the real estate boom of 2004 to 2007, had turned the property into a rental because he could not afford to sell but had to move due to a job transfer. When a personal residence becomes a rental the owner has to establish a basis for tax purposes in order to calculate depreciation. Depreciation is a wonderful write off but when a property is sold the dreaded depreciation recapture occurs potentially creating a tax liability. In addition if the property was an investment property and being sold for less than the purchase price plus improvements the loss can be written off. Note that there is a maximum of $3000 write off per year unless there are other long-term investment gains. Check with your accountant for more details.
If you are selling your home and are lucky enough to have a gain you may have to pay capital gain taxes. The IRS excludes up to $250,000 of that gain from your income if you are single. Married couples filing a joint return may qualify to exclude up to $500,000 of the gain. To qualify for the exclusion you must meet both the ownership test and the use test. You are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. Refer to Publication 523 for the complete details.
This brings us to the importance of keeping copies of ALL receipts for improvements. For example you purchase a house for $200,000. After living in the house for a few years you decide to do a major renovation at a cost of $250,000. A few years later you decide to sell and the house sells for $650,000. If you cannot provide documentation for the costs of the renovation the IRS will tax you on the capital gain of $200,000. ($650,000 sales price – $200,000 purchase price = $450,000 – $250,000 IRS exclusion = $200,000). If you can document the $250,000 renovation there would be no capital gain and therefore no tax. Check with your accountant to determine if all of the renovation costs can be deducted from the gain.
You may think capital gains tax rate would be 15%. But are you sure? Remember we are talking about the IRS who is notorious for making things as confusing as possible. According to Bill Bischoff of SmartMoney “Contrary to popular opinion, not all of your long-term capital gains are taxed at 15%. No, that would be far too simple. So in addition to the 15% rate, there is a 20% rate for upper-income investors and there are several additional long-term capital-gains rates, which can range from 0% to 28%. Last but not least, there’s potentially a 3.8% Medicare surtax on capital gains reaped by upper-income investors. Which category your profit will fall into depends on your income-tax bracket, the type of asset you sold, how long you held it and when you sold it. Keep in mind, short-term gains (on assets held for one year or less) are taxed at your ordinary income rate, which can range from 10% to 39.6%.” Check with your accountant to determine your capital gains tax rate.
Military Exclusion – If you or your spouse is on qualified official extended duty in the Uniformed Services, the Foreign Service or the intelligence community, you may elect to suspend the five-year test period for up to 10 years. You are on qualified official extended duty if for more than 90 days or for an indefinite period, you are: At a duty station that is at least 50 miles from your main home, or Residing under government orders in government housing.
IRS Resources and Publications – Publication 523, Selling Your Home, provides rules and worksheets. Topic 409 covers general capital gain and loss information. If you receive an informational income-reporting document such as Form 1099-S, Proceeds From Real Estate Transactions, you must report the sale of the home even if the gain from the sale is excludable. Additionally, you must report the sale of the home if you cannot exclude all of your capital gain from income. Use Form 1040, Schedule D (PDF), Capital Gains and Losses, and Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, when required to report the home sale. Refer to Publication 523 for the rules on reporting your sale on your income tax return. Consult with your accountant for more details.
The moral of this story is keeping every receipt for every expense while you own a property is very important. After the property is sold keep them for an additional seven years in case of an IRS audit.