There is High Value in Recordkeeping

There is High Value in Recordkeeping

You don’t like it, but you do have to accept it.

You are in a business and personal partnership with the government. One portion of your partnership agreement is the tax code.

And, certainly, there are many parts of the tax code that you don’t like, particularly the parts where you have to keep tax records. Here’s a court case that will help you appreciate the need for good tax records. It applies to all tax circumstances. It could easily apply to any person reading this post, to one degree or another.

Proving Basis in the Home

Riley and Joyce Pendergraft bought their home in San Jose, California, for $45,000. By the time they sold the house 28 years later, its value had grown to $790,000. Not bad, right?

The Pendergrafts could pat themselves on the back for some of that growth in value. They installed a swimming pool, built a second story, and remodeled the interior and exterior of the home. Overall, they estimated that the projects cost them $286,070.

Note the bad word “estimated” in the last sentence above. The Pendergrafts did not keep good records—an expensive mistake.

The Pendergrafts sold the home and claimed no taxable gain because of the $286,070 in improvements to the home.

During an audit of the Pendergrafts, the IRS found only $56,284 in improvements to the home since its purchase. The court upped that amount to $82,039, creating $101,907 in taxable capital gains. That was friendly of the court.

Since improvements add to basis and reduce taxable capital gains, keeping track of improvements is important. That’s where the Pendergrafts failed: bad paperwork. But what the heck—the Pendergrafts saved a few hours of paperwork, and it only cost them the taxes they had to pay on $101,907 of capital gains!

Whoa, what?

Records Cost

The Pendergrafts owned their home for about 28 years, and they made various improvements during those years, including a second-story addition and a swimming pool. How in the world could they keep records for 28 years?

You can find many, simple methods. One simple method is to keep a large envelope where you put the home improvement receipts and canceled checks. (Note: you need both receipts and canceled checks or other proof of payment.)

How much time would it take to put the receipts and canceled checks into the envelope? Not long. Let’s put some estimates to how much time the Pendergrafts wasted in in connection with their audit. And, certainly, keeping proper records would not have taken the estimated wasted time of 15 hours.

Now, let’s examine how much the failed record keeping cost the Pendergrafts. Let’s start with their lost time:

1. They searched the house for what records they could find (say, two hours)
2. It is uncertain, but likely they had to go to the city or county and dig out the $56,284 in costs from the building permits, which they used during the audit and which the IRS allowed as additions to basis (say, two hours with the IRS and three hours with the city and/or county digging out the permits)
3. They had to identify and then meet with the lawyer who represented them in Tax Court (say, two hours on this matter)
4. They had to pay the lawyer (say this took about one hour)
5. They testified at trial (say, four hours with waiting times, driving, and finding parking)
6. They had to pay the taxes and deal with that paperwork (say, an hour)

Given the above total of 15 hours, certainly they could have been at breakeven on the hours needed to avoid all this trouble had they just maintained the records in the first place. But the 15 hours listed above caused real anxiety, so you have to give them more weight. Let’s double that figure to 30 hours, still very conservative. Would it have taken 30 hours to maintain a simple file of all home improvement receipts and payments? Nope.

And now we have the money part. The Pendergrafts paid the lawyer who helped them. Let’s say it was a bargain price of $5,000 after taxes for this part of their tax case. And let’s be real, it is not going to only cost $5,000 to defend an audit that goes to court—heck, that barely gets your case in the door for a CPA or lawyer.

The Pendergrafts have the federal and state income taxes on the $101,907 at a combined federal and state tax rate of, say, 25 percent, for a total of $25,477. They also have federal negligence penalties of about $3,052. There’s more, of course, such as California penalties, plus interest for the time during which the taxes were underpaid.

Let’s make an estimate of, say, $35,000 in total for the failure to keep records proving the cost of improvements.

To put this in a positive frame, the Pendergrafts would have paid themselves $1,167 an hour in tax-free dollars had they kept the tax records they needed in the first place ($35,000 ÷ 30).

Get Money Back for Your Improvements

How much you spent for improvements should not be a mystery. Keep your home-improvement expenditures in a permanent file. You never know when you will need to prove the basis in your home. Further, you can’t count on the tax-free $250,000 and $500,000 being there when you sell. Tax law changes. Benefits come and go. The Tax Cuts and Jobs Act of 2017 certainly proves that point.

Home prices can escalate. You simply need to be prepared with receipts and invoices for those improvements. You also need canceled checks, which prove that you paid the bills.

Improvements add to your basis and reduce your taxable gain. This is a fundamental rule of tax law, which means you can count on this rule as long as there’s a tax code.

How does this apply to a business owner? Simple: in the event of an audit, proper records are your best friend, just as they would have been in the Pendergraft’s case. Clean and proper records are just as relevant in personal tax matters as they are in a business. Never underestimate the high value of recordkeeping.

Sincerely,

Greg Bennett, CPA