06/17/08: Secret Deductions In Community Associations
By Benny L. Kass
If you live in a condominium, cooperative or other home that’s a part of a community association, upgrades to the common areas over the years can affect the amount of tax you owe when you sell. It’s a tax break that many people overlook.
Example: You purchased your single family house many years ago for $100,000. Over the years, you have spent $50,000 in improvements and have the bills to document this. This increases your basis for tax purposes to $150,000. You sell the property for $650,000. Your profit (excluding for this discussion sales commissions and settlement costs) is $500,000. Currently, under Federal law, if you are married and file a joint income tax return, you will not have to pay any capital gains tax. If you are single – or file a separate tax return – you can exclude up to $250,000 of your profit. The difference – $250,000 – will be taxed at the current rate of 15 percent, and you will have to pay $37,500 to the IRS.
Now let us change this example to the purchase and sale of a condominium, cooperative or a unit within a community association. You bought the unit for $100,000 and sold it for $650,000. Since the IRS will consider your profit at $550,000, even if you are eligible for the up-to-$500,000 exclusion of gain, you will have to pay capital gains tax in the amount of $7,500 ($50,000 x 15 percent). However, there is a “secret” deduction you have probably overlooked, which is a very important tax benefit available to you when you ultimately sell your unit.
This column has discussed the concept of “basis” on several occasions. According to the Internal Revenue Service “You need to know your basis in your home to determine any gain or loss when you sell it. Your basis in your home is determined by how you got the home…” ” (IRS Publication 523, entitled “Selling Your Home”).
For example, if you bought or built the property, your basis is what it cost you. If it was a gift, your basis is the basis of the person giving you the property. And if you inherited the house, your basis will most likely be the fair market value as of the date of death.
Let us define some important terms:
- Gain This is also known as “profit,” and the gain on the sale of your home is the amount realized minus the adjusted basis of the home you sold.
- Amount Realized This is the selling price of your old home minus your selling expenses. These would include real estate commissions, advertising fees and legal fees incurred exclusively in the selling process.
- Adjusted Basis This is your basis in the property increased or decreased by such expenses as settlement fees or the costs of additions and improvements that have been made to your property. (A Worksheet to assist you in determining adjusted basis can be found on pages 11-13 of Publication 523).
Thus, as can be seen, in order to reduce your gain, (and pay less tax), you want to legitimately increase both your basis and your selling expenses.
Let ‘s go back to our example. You bought your community association property for $100,000. It is now worth $650,000, and you are about to sell it, and will also pay a commission of $32,500. The adjusted sales price is $617,500 ($650,000 minus $32,500). Your profit – gain – is $517,500.
Even if you are eligible for the full $500,000 gain exclusion, you will still have to pay capital gains tax on the $17,500, which at the current rate of 15 percent will cost you $2,625.
Since you purchased your property, your community association has spent a considerable amount of money improving the property. They have added a new roof (or roofs), installed a swimming pool, and made other similar improvements.
In your community association, you own a percentage interest of that association. Generally, (other than for cooperatives) your percentage interest will be found at the end of a legal document known as the “Declaration.” The total of everyone’s percentage interest in the association should be 100%. In a cooperative, your percentage interest should be reflected on your share certificate or proprietary lease.
Let us assume that the association spent $300,000 in improvements from the time you bought the property, and that your percentage interest is 1.5. If you multiple your percentage interest times the total improvements, you get a figure of $4,500, and this amount can — and should — be added to your basis as “improvements.”
It is surprising to me that many community association owners are not aware of this tax benefit. This is especially helpful for the elderly owner who is selling his or her last property, and does not want to have to pay a lot of tax on the gain that was made.
In our example, by adding $4,500 to basis, the taxpayer is going to be saving $675 in capital tax gains that would otherwise have to be paid to the IRS.
In most community associations, the records should be available as to the total expenditure for improvements on a year to year basis. Please understand that maintenance and repair items are not added to basis, but capital improvements — generally items which have a useful life of one year or more — are indeed legitimate items to be added to basis.
In recent years, community associations have exercised their statutory warranty rights and made claims against their developer. In a Private Letter Ruling, the IRS took the position that when the developer settled with the association and gave it money for the warranty claims, the owners had to reduce their basis by their proportionate share of the recovery attributable to the common areas. This is based on the percentage interest that each owner has in the association. However, the IRS also stated that the owners could increase their basis by their proportionate share of the amount spent and retained by the condominium association to make the improvements to the common areas. Thus, in this example, if the amount received from the developer by the association equaled the amount spent for improvements, this would be a wash and would cause no change to the basis of the homeowner’s property.
A Private Letter Ruling is not binding on the IRS and cannot be used as precedent for other tax matters. But it nevertheless reflects the thinking process of the IRS.
Basis is a concept on which most of us pay little attention. However, as we get older, and become concerned with conserving the majority of our assets, the concept of adjusted basis becomes critical. There is talk during this political year that the capital gains tax may be increased next year from its current 15 percent rate. But regardless of the rate, the fact remains that each dollar that can legitimately be added to the purchase price (the adjusted basis) generates a savings to the individual community association owner.
What, then, should an owner do who sold his or her property within the last few years and was not aware of this special tax break? You may be able to file an amended return, but you must discuss the logistics and the legality of an amended return with your own tax advisers.