When you buy real estate, whether your principal residence or an investment property, clearly you have to keep your records for at least four years from the date you sell that property. Profit and loss can only be determined once you sell your property, and in order to determine whether you have made any gain, you have to subtract the purchase price from the selling price.

Additionally, there are certain adjustments that can be made -- both on the buying and the selling side -- such as closing costs, real estate commissions, and recordation and transfer taxes. All of these items will be found on your settlement statements (called the HUD-1), and clearly these statements must be retained for a long time.

More importantly, under the Taxpayer Relief Act of 1997, taxpayers can exempt the first $250,000 of profit ($500,000 for married taxpayers filing a joint return). The only way that you can determine the amount of your profit is to determine the basis (adjusted purchase price) when your principal residence is ultimately sold. This means that you have to go back to the day when your very first property was purchased, to determine all of the legitimate items that can be added to basis.

Also, even though Congress has reduced the capital gains tax rate for most taxpayers down to 20 percent for Federal tax purposes, it still is important that you keep careful and accurate records of all of your improvements. For every dollar you can demonstrate was spent for home improvements, you can save 20 cents that does not have to go to Uncle Sam. And that is only at the Federal level; you may also be able to obtain a tax savings at the local and state level.

Example: You purchased investment property for $150,000, and installed a major addition in the amount of $50,000. Your basis in the property is $200,000. When you sell the property for $275,000, and do not take advantage of any of the tax saving devices (such as a "like-kind exchange"), you have made a profit of $75,000 ($275,000 minus $200,000). For purposes of this example, I am ignoring depreciation.

However, the taxpayer has the burden to prove that he/she actually made the improvement and paid $50,000. It is not sufficient merely to tell the IRS auditor that you think you put $50,000 worth of improvements in the house sometime in the late 1970's. You will be required to provide proof of the cost of these improvements. If you do not have this proof, and cannot substantiate the improvements, there is a possibility that the IRS agent will reject your claim of improvements, or reduce the amount you are claiming. You will then have to take the matter to the Tax Court, in an effort to overturn the IRS decision.

If you are eligible to take advantage of the $250,000/500,000 exemptions for your principal residence, it is also important to document what costs you incurred above and beyond the purchase price of your home.

Homeowners in some areas of the country have found their profit is above these limitations. Thus, every dollar that you add to the basis creates a significant savings for you, and puts additional money in your pocket for retirement purposes, rather than have to pay the capital gains tax.

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