What Qualifies as a Capital Home Improvement?

Home renovation projects can enhance your living space and carry financial benefits when it comes time to sell. Certain upgrades are considered capital improvements, which play a part in tax calculations for a home sale. Understanding how these improvements are defined is important for managing your home as a financial asset.

Defining a Capital Improvement

A capital improvement is a project that adds value to your home, prolongs its useful life, or adapts it to new uses. The Internal Revenue Service (IRS) distinguishes these projects from simple repairs, as an improvement must be a durable enhancement lasting more than one year. The costs of improvements affect your home’s tax basis, while routine maintenance costs do not.

Qualifying projects include structural changes or system upgrades like adding a room, finishing a basement, or remodeling a kitchen. Replacing a roof, installing a new central air-conditioning system, or adding a deck are also considered capital improvements.

In contrast, a repair merely maintains the home’s current condition. Activities like repainting a room, fixing a leaky faucet, replacing a broken window pane, or patching a small area of a roof are classified as repairs because they do not add value or prolong the home’s life.

Calculating Your Home’s Adjusted Cost Basis

Your home’s adjusted cost basis is used to calculate profit when you sell. The starting point is the initial basis: the original price you paid for the property plus certain settlement fees and closing costs like legal fees and surveys.

The cost of capital improvements is added to this initial basis to create the adjusted cost basis. The formula is: Initial Basis + Cost of Capital Improvements = Adjusted Cost Basis. For example, if your home’s initial basis was $400,000 and you completed a $50,000 kitchen remodel, your adjusted cost basis becomes $450,000.

This adjusted figure is the value used to determine your capital gain. A higher adjusted cost basis reduces the amount of gain subject to taxes, and the cost of every qualifying improvement can be added over time.

Essential Record Keeping for Improvements

The IRS requires documentation to support the costs of capital improvements, and the burden of proof rests on the homeowner. Without proper records, you may not be able to include these costs, which could increase your taxable gain upon sale.

Keep all invoices from contractors that detail the work and itemize labor and material costs. Proof of payment is also needed, so retain canceled checks, bank statements, or credit card statements. For major projects, signed contracts that outline the scope of work are also useful.

Additional documentation includes building permits and inspection reports from your local municipality. Before-and-after photographs are also useful. Keep these records for as long as you own the home, plus a minimum of three years after you file the tax return for the year of the sale.

Applying Improvements to Your Home Sale Tax Calculation

When you sell your primary residence, your capital gain is calculated using the formula: Sale Price – Adjusted Cost Basis = Capital Gain. The federal government allows most homeowners to exclude a portion of this gain from their income. Single filers can exclude up to $250,000, and married couples filing jointly can exclude up to $500,000.

To qualify for the exclusion, you must have owned and lived in the home as your main residence for at least two of the five years before the sale. A higher adjusted cost basis lowers your capital gain, which can reduce the amount that exceeds the exclusion limit and is subject to tax.

For instance, if a single filer has a gain of $300,000, the first $250,000 is excluded, but the remaining $50,000 is taxable. Increasing the adjusted cost basis with documented improvements can reduce or eliminate this taxable amount. If you receive a Form 1099-S, you must report the sale even if the gain is fully excludable.