If handled correctly, selling a home can result in a wonderful tax-free capital gain. But if handled incorrectly, it can become a taxable nightmare.
A recent Tax Court ruling showed exactly what not to do
.
Jeffrey Pesarik, a real estate manager, purchased two properties separately for a total of $743,800. One was near Boston, which he claimed was his personal residence, and the other was an investment property in Southern New Hampshire.
When he sold both of the properties in 2020, he claimed no tax was due on the sale of the Boston property because of a homeowner’s exemption. On the other home, he said that his investment in the property substantially reduced his capital gain.
The Tax Court disagreed and is charging him tax, interest, and penalties on a Capital Gain from the two properties of $255,288.
The Homeowner’s Exemption
Since the late 1990s, homeowners have been allowed an exemption of up to $250,000 (single filers) or $500,000 (joint filers) on profits from selling their principal residence. To claim this, you must live in the home for two of the past five years and cannot have claimed another homeowner’s exemption during that period.
The judge said that while Pesarik owned the Boston property, he didn’t file income-tax returns in Massachusetts or have an in-state driver’s license. He used an Arizona license to verify his identity when he sold the home.
He also noted that Pesarik’s credit-card bills went to a post-office box in Portsmouth, N.H., during much of this period. Upon examination, his utility usage didn’t show he was “definitively residing” at the property during the time he owned it.
Based on this and other evidence, Judge Urda ruled that Pesarik didn’t qualify for the $250,000 homeowner exemption. After deducting closing costs, he owed tax on $137,083 from the sale of the property.
Documenting Expenses To Reduce A Capital Gain
Pesarik’s claim for tax breaks on his other property, a run-down house he improved in Wakefield, N.H., wasn’t successful either because he didn’t keep good records.
The law allows owners of homes and other properties to lower taxes by raising their “cost basis” if they make capital improvements. Cost basis, an asset’s purchase price plus the cost of improvements, is the starting point for measuring a taxable gain after a sale.
According to the opinion, Pesarik bought the Wakefield property for $30,000 in 2016 and sold it in March, 2020 for $187,000. He claimed he had invested about $82,000 for improvements, which could have substantially lowered his taxable gain.
But the judge disagreed because Pesarik’s records were a mess. Among other things, his credit-card records for purchases at home improvement stores were vague and a spreadsheet he kept was no help either.
The court concluded that the taxable gain on Pesarik’s Wakefield house was $118,198, not $55,799 as he had claimed.
Pesarik then argued that he didn’t deserve to be penalized because he had attention-deficit hyperactivity disorder and other ills. While tax rules can be flexible when taxpayers show reasonable cause for mistakes, the judge said that Pesarik didn’t prove that his issues interfered with his ability to meet his tax obligations.
My point is that the homeowner exemption and reducing a capital gain by claiming improvements on an investment property are not automatic. Proper documentation and tax accounting are paramount to getting through any audit unscathed.
Let me leave you with this…
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