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Capital improvements are capital! Whenever you make improvements to your home that increase its value you are adding to the ledger of capital gains tax deductions you can make when you sell. The IRS considers a capital improvement something that not only adds to the home’s value, it prolongs the dwelling’s useful life or allows adaptation for new uses. The capital improvement is attached to the property. That means the installation of central air conditioning is considered a capital improvement, but interior decoration is not.
Capital improvements are a balancing act. If you’ve owned your home for ten years and replaced the carpet 8 years ago that’s a capital improvement. But – if you removed that carpet and installed wood floors, only the wood floors count as a capital improvement. The improvement must transfer upon the sale of the house.
Making Repairs Vs. Capital Improvements
It’s essential to distinguish between repairs and capital improvements, as there’s a fine line of difference. Obviously, painting, wallpapering and redecorating don’t count as capital improvements, but what about substantial repairs to a house? Generally, the answer is “no,” as the IRS doesn’t consider work that restores something to its original condition as a capital improvement, no matter how extensive. However, there are exceptions. Fixing a leaky roof is not a capital improvement if it consists of just replacing a few shingles. Replace the entire roof, and it is a capital improvement, as replacement is not restoration. The same holds true if the repair is a structural improvement, such as replacing the foundation so the house won’t collapse.
Those who live in a house are likely to make capital improvements over time, whether intentionally or not. You intentionally make a capital improvement when you add a bathroom or finish your basement. You may unintentionally make a capital improvement when you replace your broken water heater or faulty furnace because you need these fixtures to work to remain in your home. Fix the water heater or furnace and it isn’t a capital improvement. A good rule of thumb to determine the difference between repair and capital improvement: if it’s considered maintenance it’s not a capital improvement.
Fixing Design Flaws
What if you’ve discovered a serious defect or design flaw in your home and move to correct it? Generally, that’s a capital improvement as far as the IRS is concerned. For example, if your house is always cold in winter because it wasn’t insulated properly, installing good insulation is remedying a design flaw. With any type of design flaw correction, it’s wise to have an engineer or similar professional put in writing the fact that the remedy was undertaken because the original design posed a problem.
Making Capital Improvements After Disasters
If your home is severely damaged in a fire, flood or other disaster, the IRS considers everything done to restore the home to the way it was before the devastation as a capital improvement.
Capital Improvements Aren’t Tax Deductions
Capital improvements aren’t deducted on your annual tax returns. They come into play when you sell your home, and really only matter if you still owe capital gains taxes after the $250,000 exclusion for single owners and $500,000 exclusion for married couples who have called the home their primary residence for at least two of the past five years. Most people won’t owe capital gains, but there are exceptions. Say you bought your home 30 years ago for $100,000 and sold it recently for $700,000. Even if you and your spouse can exclude $500,000 in capital gains, you still have $100,000 in such gains. If you’ve made $100,000 in capital improvements over the years, and have the receipts to prove it, you won’t owe capital gains tax. Even if you haven’t put in that much money into your house, you can still add to your $100,000 cost basis with the improvements you did make, lowering the figure on which you owe capital gains tax.