How Taxpayers Can Avoid Costly Basis Errors

Just joining us?  Four previous columns spelled out basics like how to submit Form 1040-X (formerly Form 1040X), Amended U.S. Individual Income Tax Return. They also responded to a query from someone I’ll call Sadie, a freelance writer based in New York City, who needs advice on how to submit a 1040-X. Part five will discuss some of the good reasons for Sadie and other taxpayers to amend their returns.

The wrong basis for an asset. Every filing season, countless investors needlessly overpay the IRS when they sell assets because they fail to use the right basis. It’s taxes 101 that an asset’s basis is the measure of an investment in property. Basis is subtracted from the amount received from the sale of the property to arrive at gain or loss.

Sale of inherited assets. Basis errors are par for the course when the assets sold were inherited, as when the seller is a daughter who inherited a home, shares of stock, works of art, or some other asset that were owned by her father. The daughter has lots of company if she overstated the gain because she incorrectly used papa’s purchase price as a basis rather than the asset’s value at the time of his death. The frequently-missed break is that she and other heirs are taxed only on post-inheritance appreciation. Pre-inheritance appreciation escapes capital-gains taxes.

Home sales. Others who might think about amending prior years’ returns are home sellers who fail to take maximum advantage of the exclusions for profits from sales that are authorized by Code Section 121. It allows them to sidestep profits from sales of dwellings that they own and use as principal residences for periods that aggregate at least two years out of the five-year period that ends on the date of sale. Section 121 caps the exclusion. It’s generally as much as $250,000 for those who file single returns or are married and file separate returns. The exclusion amount doubles to $500,000 for joint filers.

Partial exclusions. A much-misunderstood break allows sellers to qualify for a partial or reduced exclusion when they’re ineligible for the full exclusion because they sell before two years or they exclude gain on another sale of a principal residence within the two years that precede the sale date. But the partial exclusion is available only when the primary reason for the sale is a change in employment, health problems or other unforeseen circumstances as specified by the IRS. 

Let’s suppose Waldo and Laura Lydecker mistakenly thought themselves ineligible to claim any exclusion for their gain because either: (1) they hadn’t owned and lived in their dwelling as a principal residence for at least two years out of the five-years ending on the sale date; or (2) at least two years hadn’t elapsed since they last availed themselves of the exclusion. 

Waldo and Laura are able to establish that they sold because of health problems. The IRS says it’s okay for them to submit a 1040-X and claim a reduced exclusion, provided they do so within the deadline discussed in part four.

Co-op apartments. Walter and Phyllis Neff need to file a 1040-X because they significantly overstated the gain from the sale of their co-op. What the couple remembered to do: adjust their dwelling’s basis upwards to reflect what they paid for within-the-apartment capital improvements that increase its value, such as big jobs like replacing bathrooms and small jobs like installing built-in bookcases.

What Walter and Phyllis forgot to do: adjust it upwards to reflect their share of (1) expenditures authorized by the co-op’s board of directors for outside-of-the-apartment capital improvements, such as replacing roofs or elevators or renovating lobbies, and (2) the co-op corporation’s payments of principal on an underlying mortgage on the building. These expenditures for the benefit of all apartments in their building are additional investments in their apartment. They aren’t chopped liver; they can considerably build up adjusted basis when the Neffs are owners over an extended period.

What’s next. More in the final column on other aspects of 1040-X.