Using the Cohan Rule for Home Improvements
Substantiate home improvement costs for tax purposes without complete records by using established principles to estimate expenses and adjust your home's basis.
The Cohan rule is a tax principle allowing taxpayers to estimate expenses when they lack complete records. Originating from a 1930 court case, Cohan v. Commissioner, the rule allows for estimation if a taxpayer can prove an expense was incurred but lost the receipts. While the Internal Revenue Service (IRS) prefers exact documentation, this rule provides a remedy for homeowners needing to substantiate improvement costs. This is most common when selling a home, as it offers a path to prove expenditures when invoices are unavailable.
Tax Basis and Deductions for Home Improvements
A home’s tax basis is its purchase price plus certain closing costs, like legal and recording fees. This basis is not static and can be adjusted over the life of homeownership. When a homeowner makes a capital improvement, the cost is added to the basis, creating what is known as an “adjusted basis.”
A higher adjusted basis is beneficial when the home is sold. The taxable capital gain is the difference between the sale price and the adjusted basis. By increasing the basis with the cost of improvements, a homeowner can reduce the amount of profit subject to capital gains tax. For example, adding a $50,000 deck increases the basis by that amount, thereby reducing the calculated gain on a future sale by $50,000.
Home improvement costs are also relevant for a home office or rental property, where improvements can be depreciated over time, allowing the owner to deduct a portion of the cost each year. It is important to distinguish between a repair and an improvement. A repair, like fixing a leak, maintains the property’s condition and is a deductible expense for business use. An improvement, like a new roof, adds value or prolongs the property’s life and must be capitalized.
Requirements for Using the Cohan Rule
To apply the Cohan rule, a taxpayer must meet two primary conditions. First, the taxpayer must provide credible, believable evidence that they actually incurred and paid for the expense. It is not enough to simply claim an improvement was made; there must be some proof that the work was done and money was spent.
The second requirement is to provide a rational basis for the estimated amount. The court in the original case stated that the approximation should bear heavily on the taxpayer whose inexactitude created the issue. This means the IRS or a court may allow a lower amount if an estimate seems inflated, as the burden of proof is on the taxpayer.
To meet these requirements, taxpayers can rely on various forms of secondary evidence. These documents can help demonstrate that a change occurred and corroborate that money was spent. Useful forms of evidence include:
- Before-and-after photographs
- Financial records, such as canceled checks, bank statements, or credit card statements
- Building permits from the local municipality
- Architectural plans
- Sworn affidavits from the contractor, neighbors, or a real estate professional who saw the property before and after the work
The Cohan rule has limitations. Internal Revenue Code Section 274 specifies that certain expenses, such as for travel and meals, require strict substantiation and cannot be estimated. Home improvements are not on this list, making them eligible for estimation.
Methods for Estimating and Documenting Expenses
To develop a reasonable cost estimate, a homeowner can research historical cost data for similar projects. This involves finding construction cost guides from the year the improvement was made to find average costs for that work in the same geographic area.
Another approach is to contact the original contractor, who may have duplicate records or a written recollection of the job’s cost. If the contractor is unavailable, a homeowner can get retroactive quotes from other professionals. These quotes should estimate what the work would have cost in the year it was completed.
All supporting information should be compiled into an organized file. This file should be organized logically, starting with evidence proving the improvement occurred, such as dated photos and permits. It should also include financial evidence and the documentation supporting the cost estimate. This complete package should be kept with the taxpayer’s permanent tax records, ready to be presented to the IRS in the event of an audit.