Q Dear Rick:
We recently sold our second home, which we did not owe anything on, as we can no longer afford the taxes. Being both retired is there anything to invest the money from the sale to avoid taxes on the income.
Thank you.
Mary

A Dear Mary:
Unfortunately, I have bad news for you. There is nothing you can do to avoid paying taxes on the sale. Because this is a second home and it’s not investment property, there is nothing that you can invest in or do which would allow you not to pay tax on the sale.

There are, however, some things you may be able to do to reduce the impact of the taxes. The way to do this is look for ways to increase the basis in your property. The basis is what you paid for the home plus any improvements you may have made over the years. For example, if over the course of ownership you remodeled a kitchen or bathroom, or had an addition added to the home, that would increase your cost basis, which in effect would reduce the amount of gain. Therefore, you should go back and look at all the improvements you may have put into the home whether it is a new kitchen or new flooring or something of that nature and add that to the cost basis. Of course, one of the issues that may come up is do you have receipts and documentation.

If the IRS contacts you regarding the sale of the second home, the main issue most likely will be your cost basis. If you have receipts and documentation then there’s no problem. However, what do you do if you don’t have the appropriate documentation? In that regard, there are two courses of action you can choose. The first is not to factor into the basis any improvement you don’t have documentation for. This would be the very conservative route to take and it certainly would make dealing with the IRS easier if you’re ever contacted. However, the other end of the equation is that you will pay more in taxes. The other course of action is to factor into the equation the home improvements and deal with the IRS if they contact you. The chance of being audited is slim; however, you do have to accept that you would have a risk.

Just by the fact that you don’t have receipts doesn’t mean you automatically lose if the IRS contacts you. After all, in conducting audits the IRS must be reasonable and there may be other ways to show you’ve done these home improvements without receipts. Particularly if you are reasonable when it comes to the amounts, you also would have a much better chance of prevailing than if your numbers made no sense whatsoever. All things being equal, if it was me and I did not have the receipts, I would probably factor the improvements into my cost basis and hope for the best. However, I would recognize the risk that if I was audited I may have to pay tax and some penalties.

Many people that own second homes forget that the taxation of the sale of second homes is different than on our primary residence. That is why if you do any home improvements to a second home, make sure you retain that documentation. Even though you cannot deduct these items, they will increase your basis which will eventually reduce the taxes on the sale. One last note and that is I’m frequently asked if you own a second home and you sell it as a loss, can you deduct it. Unfortunately, you cannot do that. Yes, you have to pay taxes on the gain but no, you cannot deduct losses. The bottom line, who said tax laws are fair?

Good luck!

Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com