Money spent to improve your home can save on taxes. However, the improvements have to be of a certain type, and you can’t claim the deduction until you sell your home. Capital improvement deductions usually aren’t important to sellers whose gains are less than the amount of the capital gains exclusion. But they can save thousands on taxes for people who spend a lot to improve a home and sell it for more than they paid.
A financial advisor can help you figure out how to make capital improvements work within your financial situation.
Capital Improvement Deduction Basics
Funds spend to improve a home can be deducted from the capital gains when a home is sold, potentially reducing capital gains taxes. The deductible expenses have to be for improvements that last more than a year. The Internal Revenue Service defines the term like this: “Improvements add to the value of your home, prolong its useful life, or adapt it to new uses.”
Minor repairs, on the other hand, are not deductible. Here’s the IRS definition of a non-deductible expense: “Any costs of repairs or maintenance that are necessary to keep your home in good condition but don’t add to its value or prolong its life.”
Capital improvements include:
- Additions, such as a new bedroom, bathroom, porch or patio
- Remodeling existing space such as updating a kitchen or finishing a basement
- Replacing siding, roof or windows
- Adding insulation to attic, walls, floors or ducts
- Replacing or adding air conditioning, furnace, lawn sprinkler or security system
- Adding a septic system or replacing a water heater
- Adding or replacing flooring such as wall-to-wall carpeting
- Building a swimming pool, fence or driveway or adding landscaping
Examples of non-deductible repairs include:
- Painting the interior or exterior
- Replacing broken hardware
- Filling holes and cracks
- Fixing leaks
Several exceptions exist. For instance, costs of repair-type work done during a capital improvement project can be deducted. That is, the expense of replacing a broken window, which would ordinarily be a non-deductible repair, could be deducted if done while replacing windows as part of a deductible capital improvement project.
Also, capital improvement-type projects can’t be deducted if they are not visible when the home is sold. That means costs for replacing wall-to-wall carpet aren’t deductible if, before selling the home, the owner replaces that carpet with new carpet or other flooring.
Repairs can be deducted when done on business property, including a home office or rental house. Deductions are handled differently for this sort of property. Repair costs may be deducted from income in the year during which the costs are incurred. Capital improvement costs can be depreciated over a period of years, rather than waiting until the property is sold.
How Capital Improvement Deductions Work
When a home is sold, the seller may have to pay capital gains taxes on the difference between the sale price and the cost basis. Capital improvements can reduce this tax by increasing the cost basis for a home. The original cost basis is the purchase price of the home, including closing and other costs. Any capital improvements that are done after closing are added to this cost basis.
For example, say a homebuyer purchases a home for $200,000 and sells it after 20 years for $500,000. The difference between the $200,000 cost basis and the $300,000 sale price is $300,000. This is the homeowner’s capital gain on the transaction and the amount potentially subject to capital gains taxes.
However, while owning the home, the owner spent $75,000 on capital improvements, including a new roof, a swimming pool and a kitchen remodel. Adding $75,000 in capital improvements to the $200,000 purchase price brings the cost basis to $275,000. Now the gain on the sale is $500,000 minus $275,000 or $225,000.
Capital gains taxes range from 0% to 20%, depending on the seller’s income and how long the property was owned. Assuming a 15% capital gains tax, deducting $75,000 in improvements could save this taxpayer $11,250, equal to $75,000 times 15%.
Capital Improvement Deduction Limitations
Capital improvement deductions aren’t useful for every homeowner. Federal law excludes many gains on sales of primary residences from capital gains taxes. This home sale exclusion is capped at $500,000 for couples and $250,000 for individuals.
In the above example, the gain before capital improvement deductions would have been $300,000, so the taxpayer may have owed taxes on part of the gain before deductions. However, homeowners who realize a gain on sale of their homes that is below the exclusion cap don’t owe taxes on the gain.
Another limitation is that home sellers can’t deduct a capital improvement that has received a tax credit. For example, if a homeowner gets a tax credit for adding solar panels, the cost of the panels can’t be deducted as a capital improvement.
Taxpayers also may need to document the cost of the repairs using receipts and invoices, so it is best to keep accurate and completed records. Repair costs don’t have to be documented when claimed, but the IRS may later ask to see proof.
Costs of capital improvements can be deducted from taxes on gains when selling a home. Only certain improvements can be deducted and many repairs are not deductible. Home sellers whose gains are less than the exclusion from capital gains won’t benefit from deducting capital improvement costs.
Capital Improvement Tips
- A financial advisor can help you evaluate the dollars and cents of decisions about buying, improving and selling a home. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When a home sustains damage from natural disaster or fire, any expense required to return the home to its previous condition is a deductible capital improvement. That includes projects that would otherwise be non-deductible repairs.
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