The Cohan Rule: Estimate Your Expenses For IRS Deductions

Written by Posted On Thursday, 14 June 2018 13:09
Question: I built my own house. At first I stuffed receipts into a folder but toward the end when things got hectic, I forgot. I probably have receipts amounting to a quarter of what I believe I spent, land included. How can I establish a credible basis when it comes time to sell? The good news is the house is probably now worth a million and I think I spent less than $150k. Warren.

Answer: Warren, We all have those stuffed receipts, although usually they are in a shoe box and not a folder. But all is not lost. Remember the song "I'm a Yankee Doodle Dandy". It's author was George M. Cohan. Why do I mention this? Because the so-called "Cohan rule" will assist you.

Oversimplified, Mr. Cohan did not keep good records; in fact, it appears that he did not keep any records, based on his busy schedule. When he included lots of expenses in his tax return, it was rejected. However, on appeal, Judge Learned Hand reversed the IRS. The Cohan rule basically means that you can estimate your expenses so long as you can show there is some basis for the deduction; in other words, can you prove you made improvements to your house?

In the words of the Court: "it is not fatal that the result will inevitably be speculative; many important decisions must be such."

Additionally, I have heard tax lawyers point out that section 274(d) of the tax code only requires substantiation for gifts, travel and entertainment. Since home improvements are not included in that list, you can rely on the Cohan rule.

However, discuss your situation with your own financial and legal advisors. I cannot provide specific legal advice.

Question: With all of the difficulties being experienced in the real estate marketplace and by related businesses, there is one question I have never seen asked and answered anywhere. Specifically, what would happen to my title insurance policies (both lender and owner's) if my title company were to go out of business? - Jon.

Answer: Jon. That's a great question. First, let's provide some definitions.

There is a title company. In the West, they are called "escrow companies". The title company conducts the settlement, arranges for all legal documents (promissory note, deed of trust, truth in lending, etc) to be signed and notarized, gathers in the funds from the buyer and the mortgage lender (if applicable), records the legal documents among the land records in the jurisdiction where the property is located, and then disburses the settlement proceeds according to the settlement statement (which is called a HUD-1).

There is also a title insurance company that writes the title policy for both owners as well as lenders. The title (or escrow) company is an authorized agent for a title insurance company and has the right to issue the policies on behalf of that company.

If the title company goes out of business for whatever reason, you still have the protection under your title policy by the insurance company on which the policy was written. They are what is known as the underwriter.

But what if the underwriter -- the insurance company itself -- goes out of business? Every such company is regulated in every state in which they do business by the State Insurance department. The underwriter -- just like any other insurance company -- is required to maintain reserves, which are monitored carefully by the state insurance commissioner. And to my knowledge, most -- if not all -- states have policies in place to protect the insured in the event the company goes out of business. In many situations, other insurance companies have to take over and assume the obligations of the failed company.

If you have more questions, I am sure that your state's insurance department will be able to provide specific details about your state's policies.

But your question prompted me to remind all homeowners: when you went to closing you probably purchased an Owner's title insurance policy. Typically, the title (escrow) company will want to record the legal documents first. Then when they are finally received back from the Recorder of Deeds, you will get the original recorded deed plus a copy of your title insurance policy.

It often takes months to get the documents back from a Recorder of Deeds. So don't forget to make sure that ultimately, you get a copy of your title insurance policies.

Question: My father added my brother and I to the deed of his house he bought back in 1979. Now that he did his living trust, he wants to remove us from title (Deed) so we don't have to pay taxes in case something happens to him. I understand his property taxes will go way up is that correct. Should he leave it like it is or remove us from title? Martha.

Answer: Dear Martha. Property taxes will not go up merely based on your dad removing you from title. I have heard this from several readers, and unless someone can document why this happens, I don't believe it to be true.

However, in most cases, I don't like parents putting their children on title; that is considered a gift and the tax basis of the giftor (your dad) becomes the tax basis of the giftee (you and your brother). That means that on his death, and if you want to sell the property, you potentially will have made a profit -- albeit a phantom profit.

On the other hand, if you and your brother inherit the house on his death, you get what is known as the "stepped-up" basis -- ie the value of the property on the date he died. Thus, if you sell it shortly thereafter, you will probably make no profit and thus not have to pay any capital gains tax.

Question: I have a similar situation; my mother bought a home by herself about 10 years ago and has recently added my name to the deed. I was told that when my mother passes away I will have to pay a higher tax because I was added to the deed rather than my mother granting me the house through her will/estate. I am not living in the house either. I am very confused about what steps we need to take to make this a smooth and least costly event for my mother and me. Thank you. Erika.

Answer: Dear Erika: See my response to the question above yours. Yes, let's say your mother bought the house for $100,000 and made no improvements. When she dies, the property is valued at $500,000. If you inherit the house, your tax basis is stepped up -- in other words, the value of the house on your mother's death is that basis. So if you sell for $500,000, you have made no profit and thus do not have to pay any capital gains tax.

But if she gave you half of the house, your basis is $50,000. Now she dies. You get the stepped up basis for your mother's half -- ie $250,000, but you overall tax basis is ow $300,000 ($250,000 + 50,000). If you sell for $500,000, you will have made a profit of $200,000 and unless you will have owned and used the house for two out the five years before it was sold, (in which case you can claim the up-to-$500,000 exclusion of gain or up-to-$250,000 if you file a single tax return) you will have to pay capital gains tax on your gain.

The bottom line: in most cases, it makes no sense for a parent to gift a portion of the house (or all of it) to their children. But talk with your own financial advisors about your specific situations.

Question: I recently got engaged and have plans to have my new fiancee move in to my house. I am currently the sole owner of the home. We have a wedding date scheduled for over 2 years from now. He makes much more money than I do and has a greater tax liability. Would it be advisable and/or beneficial to add him to my mortgage and title to allow him to attain the tax benefits? I believe the right off would be much more meaningful to him, but I don't want to make a mistake that will cost me more money in the future. Tori.

Answer: Dear Tori. Congratulations. I never want to break up a relationship and I don't do divorce law. But two years is a long time, and who knows what the future will bring.

I don't think it is a good idea to put him on title. And it will cost you (or him) a lot of money to do it. You will have to pay your state (and possibly) local recordation and transfer tax, and your lender will want a brand new settlement (closing/escrow) in order to put his name on the deed and the mortgage.

If you do decide to do this anyway, talk with a lawyer and enter into a written partnership agreement with him before his name is added to title. And title should be held as "tenants in common"; so that you preserve at least half of the property should you split up or should one of you die before the marriage.

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Benny L Kass

Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.

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