When it comes to taxes, there rarely are quick questions. Or, let me put it another way, if you consistently get quick answers from your quick questions – run, don’t walk, to another advisor. That’s because on the surface it might seem like a quick question, but there is often more to it. For example, “I am selling my principal house that I lived in for over two years and getting back $100,000, do I have to pay tax?”
This “quick question” happened at a seminar. My question back was, “What’s your basis?” I got a blank look and a long silence.
It doesn’t matter how much cash you put in your pocket. The cash back has nothing to do with the gain you pay. That gain is calculated by looking at the sales price, selling expenses, basis and past depreciation that has to be recaptured.
When it comes to selling an asset, you’ll always need to know two things: (1) The basis (2) The date of purchase
Actually, you’ll need to know more than that to calculate the gain, but those are the two things that most real estate investors or home sellers have trouble with.
The basis is adjusted by any roll-over deferred gain, depreciation and improvements, so you can’t even say that your basis equals the amount you paid. That’s one of the reasons that I devote so many pages to step-by-step guidance on how to calculate gain in Easy Accounting for Real Estate Investors.
And, when it comes to real estate, there are a lot of creative buying and holding techniques that can distort the cash so that it has nothing to do with the amount of taxable gain. For example, the lady with the principal residence question in the leading paragraph might have done a number of things that got her $100,000 cash back when she sold. She might have: put a big (or small) amount down when she purchased, or refinanced to pull cash out, paid down the loan with mortgage payments. There are just way too many possibilities to consider when you’re trying to estimate the amount of gain you have on a sale. The only way to be sure is to know the basis and date of purchase.
The same is true, in a slightly different way, for a business owner. I had a client who came in once convinced that he didn’t owe any taxes because he had no money in his account! Of course the cash could have gone to buy assets (not a deduction), to pay down debt (not a deduction) or for personal use. On the other hand, just because you have money in the bank, it doesn’t mean you’re profitable. A loan or capital contributions can pump up a cash balance.
Bottomline: Cash does not equal income.
What does all this have to do with “quick questions?” Well, usually the quick questions have to do with how much tax is due…but there are no quick questions when it comes to this.
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