What is a ‘Capital Improvement’
A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property’s overall value, increase its useful life or adapt it to new uses. This type of improvement, according to the Internal Revenue Service (IRS), must have a life expectancy when installed of more than one year. Although the scale of a capital improvement can vary, both individual homeowners and large-scale property owners make capital improvements.
BREAKING DOWN ‘Capital Improvement’
As outlined by IRS Publication 523, a capital improvement is an improvement that adds to the value of a home, prolongs its useful life or adapts it to new uses. Such costs can be added to the cost basis of a home. Examples of capital improvements include adding a bedroom, bathroom or deck; adding new built-in appliances, wall-to-wall carpeting or flooring; or improvements to a home’s exterior, such as replacing the roof, siding or storm windows. For the improvement to qualify as a cost basis increase, it must be in place at the time of sale. A capital improvement must also become part of the property or must be permanently added to the property so that the removal of it would cause significant damage to the property itself.
For example, if a person buys a new hot water heater and a tool shed for his property, both of which are attached to the home, they would be considered capital improvements to the house. Similarly, the creation of a new public park in a downtown area would also be considered a capital improvement for a city. In these scenarios, the new additions would make the respective properties more valuable, would be considered permanent additions, and their removal would cause material harm to the home and the city’s property.
Capital Improvements Versus Repairs
The IRS makes a distinction between capital improvements and repairs, which cannot be included in a property’s cost basis. Repairs done as part of a larger project, such as replacing all of a home’s windows, do qualify as capital improvements. Repairs that are necessary to keep a home in good condition, however, are not included if they do not add value. Examples of such non-qualifying repairs, according to the IRS, include painting, fixing leaks or replacing broken hardware.
Capital Improvements and a Property’s Cost Basis
In addition to improving the home, a capital improvement (per the IRS) increases the cost basis of a home, which in turn reduces the taxable capital gain when selling the property. Capital improvement deductions are not necessary for everyone, however. As of January 2018, homeowners are entitled to a capital gains exclusion on a gain from the sale of a primary residence (up to $250,000 if single and $500,000 if married), given that the homeowner lived in that residence for at least two of the last five years before the sale.
Assume, for example, a person purchases a home for $650,000 and then spends $50,000 to renovate the kitchen and add a bathroom. The cost basis of the home, therefore, increases from $650,000 to $700,000. After 10 years of owning and living in the home, the homeowner, who is single and files his taxes as such, ends up selling the property for a price of $975,000. If no capital improvements had been made, the taxable amount for the capital gain would have been $75,000, derived as $975,000 (sale price) – $650,000 (purchase price) – $250,000 (capital gains exclusion). However, because the capital improvement increased the cost basis by $50,000, the taxable amount for the capital gain would be $25,000, calculated as $975,000 – ($650,000 + $50,000) – $250,000.