Even though profits (up to $250,000 for singles and up to $500,000 for married couples) on the sale of your primary residence are no longer taxable, you should keep all records related to the sale and purchase of your home(s), including settlement papers and documentation for improvements or additions to your home. To calculate whether you can claim exemption from taxes if you make a gain on the sale of your house, you have to be able to accurately document its cost basis. If you bought or built your home, the original basis is the price you paid, plus any closing costs. Improvements you make to your home increase your basis as long as they pass the IRS requirements of adding to the value of the house, extending its useful life, or adapting it to a new use. You must differentiate between improvements and repairs. Repairs can’t be added to the basis of your home. If you hire contractors to do improvements, the entire cost can be used to increase your basis; if you do the work yourself, you can only add the cost of materials.
Even thinking about IRS audits frightens most people, but they’re really not that scary (unless you’ve intentionally committed fraud—then you should be scared). Most audits are really about mistakes and mismatched documents, and can be solved quickly without you ever having to be in the same room as an auditor. Very few people actually get in-person audited, but millions will receive IRS letters pointing out errors that need to be corrected or explained. If you do get one of those letters, or even if you get called in for an audit, don’t panic—get your paperwork together. Being prepared is more than half the battle.
The Importance of Documentation
Some characteristics of a tax return, such as having income over $500,000 or experiencing dramatic swings in income, may increase your chances of being audited. But as long as you reported everything accurately and have documentation to prove it, you have nothing to worry about.
The most basic thing you can do to reduce your chances of being audited is to make sure there are no errors on your return, which can be easy to make when you’re typing in a lot of numbers. Most tax software lets you import tax documents, which cuts down substantially on mismatch mistakes. Make sure Social Security numbers for you and your dependents are accurate. If you can’t file your return by the April 15 deadline, file for an extension before the deadline. Be sure to sign your return.
It can be upsetting to finish your tax return and realize you owe additional tax and don’t have the money to pay it. Though you may be tempted to put off filing until you can pay, filing your tax return late will add to the problem. To avoid extra penalties, which will make your tax bill even bigger, file your tax return by the due date or file for an automatic extension even if you can’t pay the full amount of tax due. Pay as much as you can to reduce future interest charges.
The IRS offers four options to help you pay off the rest of the taxes you owe. They’re willing to work with anyone who truly can’t pay their tax bills in full on time, but you have to be the one to contact them. The four main IRS payment options include:
To ensure that you don’t owe a lot of taxes, review your withholding every year and make sure you’re having enough taken out to cover your income. If you receive income that taxes weren’t withheld from (such as from freelancing, or investments), make quarterly estimated tax payments or increase the amount of your withholding at work to compensate.
Estimated tax is the method used to pay tax on income that is not subject to withholding. This includes earnings from self-employment, interest, dividends, and rents; essentially any income you receive that doesn’t have taxes taken out of it. The IRS website (www.irs.gov) has an estimated tax worksheet that can help figure out how much you’ll need to pay each quarter to avoid getting hit with tax penalties. Estimated taxes can be paid by mail (along with IRS Form 1040-ES) or online.
You can avoid incurring tax penalties for underpaying taxes by estimating your tax liability before the end of the year to allow time to catch up if you’ve under-withheld. If your tax status has changed during the year, visit the withholding calculator on the IRS website to see if you need to make an adjustment. To avoid penalties, you must pay at least 90 percent of your tax for the current year before December 31, or 100 percent of your total tax liability for the prior year (110 percent if you earn more than $150,000).
If it looks as if you may not have had enough tax withheld, change your withholding by filing a new W-4 with your employer to have additional tax taken out each pay period through the end of the year. After the start of the new year, complete another W-4 to adjust your withholding back to a more normal amount.