Is It Ever Legal To Not Pay Taxes?

In some cases it is legal to not owe or pay taxes when you sell your primary residence. Here is how it works:

“Let’s start from the very beginning, a very good place to start”. 

The first issue is to know the "basis" of your home. Your original cost basis is the amount of money you paid for your home. But during the time period you owned and lived in your home, the original cost basis can be adjusted up or down dependent on things like capital improvements to the home, depreciation[1], or damage that causes a reduction in value.

When you sell your home, you can have a gain or a loss, but how the IRS views that gain or loss can vary. For now think of it like buying a stock and holding onto it for a number of years before selling it. And then, upon the sale you either made money or lost money.

To determine if you have a gain or a loss, know that your basis is the beginning point for gain or loss calculation. Then take into consideration the amount for which you sell the property.[2]

 

For the sake of this story let’s assume the only thing affecting the value of your home is appreciation. Therefore, the capital gain on your home sale is the difference between the sale price and what you originally paid for the home. If you have owned and lived in your home for many years, that capital gain may be a significant amount.

121 Exclusion:  The IRS says in most cases up to $250,000 in capital gains ($500,000 for a married couple) is exempt or tax-free provided the home was your principal residence for two out of five years prior to the sale. 

Be aware, however, that this exclusion does not apply to investment properties (rentals)[3], second homes, when a home or a partial interest in a home has been gifted to you, or for joint ownership with children, or real estate inheritances.

In the case of an inheritance, however, there is another tax allowance and that is you are able to claim "stepped-up basis". This means your basis for the inherited home is “stepped up” to the market value of that home on the date you received it. The capital gain when you sell it is then calculated using your stepped-up value vs. the original basis, and this could save you thousands of dollars in taxes. Note that this is also true of inherited stocks, bonds, ETF’s or mutual funds. Keep in mind we are only focusing on capital gains tax here as other taxes may apply, but that is an entirely different story!

Because tax code changes every year, many taxpayers are unaware of how the step-up in basis works, and wind up gifting[4] their home to their heirs or change to joint ownership with their heirs assuming they are saving on estate, capital gains and inheritance taxes. But doing this could present their heirs with a large tax liability upon sale.

There are also situations where the step-up in basis is not straightforward, for instance when one spouse passes away, and the home is held in joint tenancy with right of survivorship. In this situation the surviving spouse receives a half-step-up in basis, based on the fifty-percent of the home that the deceased spouse owned.

When “gifting” occurs there are many considerations such as the gift tax implications (again a story for another day) and the loss of stepped up basis. How you calculate the basis of gifted property depends on whether there will be a gain or a loss. 

For determining gain, the gifted basis is the same as that of the original owner and this is known as “carryover” basis. It is for this reason that planners suggest holding onto a highly appreciated asset and bequeathing it instead of gifting it.  This choice could save your heirs thousands of tax dollars.

When a gifted asset loses or depreciates in value to less than the donor’s original cost, the recipient’s basis is the fair market value (FMV) of the asset at the time of the gift. So say a donor paid $100 for some stocks that he or she then gifts and when the gift occurs the shares are worth $50. By the time the recipient sells the shares they are only worth $25. Here is how that loss would be calculated:

$50 (FMV at gifting) -$25 (sale price) = $25 loss

Using the same original donor basis of $100, if the value of the asset had appreciated and was $200 when gifted but dropped to $50 when the recipient sells it, you would calculate loss this way:

$100 (donor basis) - $50 (sale price) = $50 loss

While we suggest keeping in mind 121 exclusions, stepped-up basis and gifting vs. bequeathing when considering the disposition of your home, or any asset, we realize that other factors may influence your specific situation. Therefore, always make an informed decision. It is best to consult with a professional before “winging it”.

---

^[1] Depreciation is a  reduction in the value of an asset over time, due typically to wear and tear and it is an indication of how much of an asset’s value has been used up; in general this applies only when the a tangible asset (in this case your home) has been used for business or rental purposes.

^[2] Although the IRS may exempt or realize some or all of the gain, you cannot take a loss on the sale of a primary residence.

^[3] Rental or other business properties, vacation homes, and part rentals are subject to an entirely different set of rules and taxes, potentially including a tax on “depreciation recapture”.

^[4] Gifting occurs when an asset is transferred to another while the original owner is still alive; a bequest is when an asset is transferred to someone else postmortem, and this is known as an inheritance.

What To Do If You Get a Notice From the IRS (after you stop crying)!

Each year the IRS mails millions of notices. Here’s what you should do if you receive a notice from the IRS:

1. Don’t ignore it. You can respond to most IRS notices quickly and easily. And it’s important that you reply promptly. 

2. IRS notices usually deal with a specific issue about your tax return or tax account. For example, it may say the IRS has corrected an error on your tax return. Or it may ask you for more information.

3. Read it carefully and follow the instructions about what you need to do. Or call your tax accountant. Some issues are best handled by a professional whereas, some situations you can resolve on your own. 

4. If it says that the IRS corrected your tax return, review the information in the notice and compare it to your tax return.

• If you agree, you don’t need to reply unless a payment is due. 
• If you don’t agree, it’s important that you respond to the IRS. Write a letter that explains why you don’t agree. Make sure to include information and any documents you want the IRS to consider. Mail your reply to the IRS at the address shown in the lower left part of the notice. Allow at 30+ days for a response from the IRS. 
• You can handle most notices without calling or visiting the IRS. If you do have questions, call the phone number in the upper right corner of the notice. Make sure you have a copy of your tax return and the notice with you when you call, a cup of coffee and a headset - it may be a while. 
• Keep copies of any notices you get from the IRS. 
• Don’t fall for phone and phishing email scams that use the IRS as a lure. The IRS first contacts people about unpaid taxes by mail – not by phone. The IRS does not contact taxpayers by email, text or social media about their tax return or tax account.

For more on this topic visit IRS.gov. Click on ‘Responding to a Notice’ at the bottom left of the home page. Also see Publication 594, The IRS Collection Process. You can get it on IRS.gov or call 800-TAX-FORM (800-829-3676) to get it by mail.

Beware the Hobby Loss Rule: A Very Costly Mistake

If the IRS thinks you have a hobby instead of a business, it could cost you a lot in taxes.

If the money you spend more money on your business than you earn, your business incurs a loss. However, if you keep reporting losses year after year, you need to be very concerned about running into trouble due to the “hobby loss rule.”  This rule could cost you a fortune in additional income taxes.

The IRS created the hobby loss rule to prevent taxpayers from repeatedly deducting losses. If a business shows a loss for three years out of five, then the IRS considers the activity to be a hobby. A venture is considered a business only if you engage in it to make a profit.

If you keep incurring losses and can’t satisfy the profit test, you must be prepared to convince the IRS that your business is not a hobby in case you’re audited--and there is a good chance you will be audited.  

How do you prove you are seriously involved in the business for money making purposes? The IRS looks closely at the manner in which the activity is carried out and there are nine regulatory guidelines:

1.      The manner in which the taxpayer carries on the activity. Are there complete accurate books, a budget, and separate accounts?

2.      The expertise of the taxpayer or his advisers. Did the taxpayer study the activities business practices? Did they consult with experts?

3.      The time and effort expended by the taxpayer in carrying on the activity. Do they devote a lot of time to the business particularly in comparison to other employment?

4.      The taxpayer’s history of income or losses with respect to the activity.  Has the taxpayer become profitable in a reasonable amount of time?

5.       The expectation that the assets used in the activity may appreciate in value. Is the plan to generate profits through asset appreciation?

6.      The success of the taxpayer in carrying on similar or dissimilar activities. Have they been able to convert the activity from unprofitable to profitable?

7.      The financial status of the taxpayer. Does the taxpayer have other income sources that are being offset by the losses of the activity?

8.      The amount of occasional profits. Consistent loss is a red flag.

9.      Does the activity lack elements of personal pleasure or recreation? If the activity has large personal elements it is indicative of a hobby.

If the IRS deems a business as a hobby, the income is reported as "other income" on Form 1040. But “Hobby Expenses” are only deductible if you itemize deductions. They fall under “miscellaneous deductions" and you can only deduct the portion that, along with any other miscellaneous deductions, exceeds 2% of your adjusted gross income. Depending on your particular tax circumstances this can result in all income from the hobby being taxable income with no offsetting deduction for hobby expenses.