What Is Capital Improvement and How Can You Benefit From It?

✏️ Editor’s Note: Realtor Associations, agents, and MLS’ have started implementing changes related to the NAR’s $418 million settlement. While home-sellers will likely save thousands in commission, compliance and litigation risks have significantly increased for sellers throughout the nation. Learn how NAR’s settlement affects home sellers.

Americans spent an average of $8,484 on home improvements in 2022. Moreover, they had to spend $1,953 on emergency repairs and $2,467 on maintenance. That’s a total of $12,904 in out-of-pocket spending on a home. Oof!

But there’s a silver lining here. You see, Uncle Sam provides capital gains tax relief on these improvements at the time of the sale. This could help you save up to 20% of your profits based on your tax bracket.

However, you can avail of this benefit only if the enhancement qualifies as a capital improvement.

What Is a Capital Improvement?

A capital improvement is a permanent change or a restoration of a property. It either enhances the property’s value, extends its useful life, or adapts it to new uses.

Here are some examples:

• Adding a room
• Replacing the roof
• Laying a wall-to-wall carpet
• Installing centralized air-conditioning
• Adding ramps or rails to accommodate for disabilities

The IRS specifies that the life expectancy of the enhancement must be longer than a year. Only then is it considered a capital improvement.

The Role of Cost Basis in Capital Improvement

You can’t deduct a capital improvement expense from your taxable income like the usual write-off. Instead, the cost gets added to your property’s original price, a.k.a., the cost basis.

Let’s say you bought your home for $300,000. That’s the original cost basis of your property. Over the years, you spent $60,000 on capital improvements. Now, the new cost basis is $360,000. The higher the cost basis, the lower the amount you owe in capital gains taxes after the sale.

But not every home improvement increases the cost basis. To count towards the cost basis, a home improvement must be:

• A permanent fixture of the home
• A desirable feature
• An enhancement that increases the home’s value

What a Capital Improvement Means for Your Taxes

When you sell your home, you owe capital gains tax on the profit. However, the IRS allows individual filers to exclude up to $250,000 in profits from the sale. If you file a joint return with a spouse, you can exclude up to $500,000 of that profit.

Any home improvement that adds to the cost basis can help you avoid the capital gains cap.

How It Works

Let’s say you bought a house for $300,000. You added a new bedroom, which cost you $25,000. That brings your cost basis to $325,000.

Now, fast-forward six years. You and your spouse decide to sell this house, and someone buys it for $850,000— great news! Here’s how the math works to determine your tax liability:

• You sold the house for $850,000.
• Your updated cost basis (after that bedroom addition) was $325,000.
• The difference between what you sold it for and your updated price tag is your profit, which, in this case, is $525,000 ($850,000 – $325,000)

You and your spouse can get up to $500,000 tax exemption jointly on the profit from the sale. But what if your proceeds exceed that value, as in the above example? Here’s how the math works for this scenario:

• With the bedroom addition included, your profit was $525,000.
• You don’t owe taxes on the first $500,000, thanks to the capital gains tax benefit.
• That leaves $25,000 of your profit that could be taxed.

If you didn’t count that $25,000 bedroom addition in your cost basis, you would have a larger taxable profit of $50,000. That’s because without including the bedroom, it looks like you made more money on the sale.

Capital Improvement vs. Repairs

The IRS differentiates between capital improvements and repairs from normal wear and tear. In the latter’s case, the expenses do not contribute to the cost basis. Hence, one-off fixes won’t reduce your tax liability.

⚠️ Exceptions: You can get tax benefit on repairs if you own a rental property. Here, repair expenses cut into your business income, which reduces the tax burden.

You can fully deduct the cost of repair expenses in the year they’re made, provided they’re necessary, ordinary, and reasonable in amount. This includes repainting, fixing floors or gutters, fixing leaks, and replacing broken windows.

The Gray Area

What happens when a small repair turns into a full-fledged renovation project? What expenses count towards the cost basis?

To navigate this gray zone, the IRS employs fact and circumstance analysis. As per this method, the IRS will only promote a repair to capital improvement if it’s for:

• Betterment: This includes any repairs that cure a major defect or add to the property’s safety. For instance, if you live in a hurricane-prone area, installing hurricane shutters is a betterment.
• Adaptation: This includes any repairs you make for adaptation purposes. For instance, if you want to renovate your house for rental use, you adapt it to new use. Another example of adaptation is repairs made to accommodate for disabilities.
• Restoration: This includes any repairs you make to restore your house to its original condition. It usually applies when there’s damage or loss to property due to a fire, flood, or natural disaster.

The Bottom Line

Capital improvements can help you avoid capital gains taxes when you sell your house. However, it’s essential to clarify what improvements are capital improvements to avoid a nasty tax surprise later.

Also, the IRS keeps updating the list of improvements that qualify as capital improvements. So, stay updated on the latest tax regulations. You can also consult a tax expert to understand your tax liability during your home sale.

FAQs

• Seller