Home Improvements Must Be Permanent to Be Included in Residence’s Cost Basis

QWe have lived in our home for 20 years and over time have made many costly improvements, some of which no longer exist. For example, we remodeled the bathrooms twice and built a deck and lap pool that were later removed. We are in the process of selling the house and wonder whether the costs of these “disappeared” improvements may be added to the home’s cost basis to reduce our potential taxable gain from the sale. We have pictures and records to prove the improvements were made.

--K.S.

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AThe Internal Revenue Code allows a taxpayer to include the cost of “permanent improvements” to his or her home to the residence’s cost basis. The important word here is “permanent.” Clearly the improvements you discarded or replaced do not meet this test.

According to our experts, if you are going to follow the strict letter of the law, you should not include these now-demolished improvements when you compute the cost basis of your residence. If you decide to include the costs of the temporary remodeling--on the theory that the IRS can’t possibly know the difference between a $15,000 kitchen overhaul and a $25,000 one--be advised that this could be considered tax evasion. If you are audited and cannot produce receipts to support the cost you assigned to the permanent improvements, your deduction would probably be disallowed and you could be subject to more serious charges.

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Q The company for which I work has 75 employees all working for the owner-president. I think we ought to have a 401(k) plan, but the boss says it is too costly and time-consuming to administer and manage. Is that true? How difficult is it for a company to start and maintain a 401(k) plan?

--V.T.

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A Establishing a 401(k) plan is the easy part. Maintaining it is another issue. According to the experts we consulted, your employer is right: It is costly and time-consuming to administer a 401(k) plan, especially for a relatively small company such as yours.

But there are some considerable advantages to a 401(k) plan for both employers and employees.

What sets 401(k) plans apart--and the principal reason for their popularity among workers and bosses--is the tax-deferred status of employee and employer contributions to the accounts.

In general, our experts say, employers can expect to spend at least an additional 50% annually to operate their profit-sharing plans as bare-bones 401(k) programs. Why? For starters, the plans require regular payroll deductions. Then there’s bookkeeping for each employee’s account and handling of hardship withdrawals and other paperwork. In addition, employees must be notified at least annually about how their accounts are faring. Employers can expect higher costs if they offer more frequent account updates and multiple investment choices for participants.

So why do many employers bother with these plans?

Employees like you say they want them as a type of forced savings for their old age as well as a tax-avoidance scheme for now. Their major appeal is the tax-deferred accumulation of savings for retirement at a time of increasing concern that traditional pensions and Social Security will be insufficient to cover basic needs.

Another major draw is the fact that most employers allocate what they once spent on their traditional profit-sharing funds to match employee deposits in their 401(k) accounts. The enormous popularity of 401(k) plans among employees had led many leading companies, already burdened by the tremendous increase in employee health insurance costs, to shift their traditional pension plans to 401(k) programs to save money.

At the same time, employers have discovered that they actually end up contributing less to 401(k) plans than they paid out in profit sharing--even after paying the extra administrative charges.

Why? Under a profit-sharing plan, only employers put in money. But with a 401(k) plan, the employer generally matches only the contributions made by employees--usually by 50% or less. (In a few cases, companies make additional, unmatched contributions to their employees’ accounts. And some do no matching at all.)

Overall, because not all employees want or can afford to set up a tax-deferred savings account, companies usually end up contributing less to 401(k) plans than they did to the straight profit-sharing program. One informal study by a bank trust department found that employers who traditionally contributed 10% to 12% of their payrolls to a profit-sharing plan paid out 5% or less into a 401(k) program.

Do employees really come out ahead with a 401(k) plan--or are they better off with a straight profit-sharing check every year? There is no single answer that applies to every worker.

If you need your profit-sharing check to make ends meet, a 401(k) plan is not going to help you much since you will probably get nothing from your employer without contributing to your account. And what you do get won’t be freely available to you until age 59 1/2.

If you simply spend your profit-sharing money because it’s there, a 401(k) plan could be just the savings discipline you need, regardless of whether you want it.

But if you’re a saver, a 401(k) plan has to look like heaven to you because your money is likely to be matched and accumulations are tax-deferred.

One final caveat about 401(k) plans bears underscoring: These accounts can be difficult for employees to manage. Unlike unilateral profit-sharing plans in which funds are administered by corporate executives or professional money managers, most 401(k) plans offer employees a wide and often mind-boggling array of investments from which they must choose. There are stock funds aimed at growth and stock funds aimed at generating dividend income. There are bond funds, international stock funds and funds mysteriously called “balanced.” Few of us are trained to make these momentous and sophisticated decisions. But with 401(k) plans, we are usually entirely responsible for the performance of our accounts. If we choose the wrong funds or move our money around at the wrong time, our investment could languish or--worse--be wiped out.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com