Capital Improvements

utah real estate tax attorney

All capital improvements to your home are tax deductible. You cannot claim the deduction until you sell it when the cost of additions and other improvements are added to the cost basis of your property. The IRS defines a capital improvement as a home improvement that adds market value to the home prolongs its useful life or adapts it to new uses. Minor repairs and maintenance jobs like changing door locks, repairing a leak or fixing a broken window do not qualify as capital improvements.

Home Additions

New additions to your home are the most obvious capital improvements. Adding a new bedroom, bathroom, garage, porch or even a satellite dish to your home are all valid improvements, according to IRS Publication 523.

Heating and Air Conditioning Systems

You may deduct any costs expended towards the installation of a new heating system, central air-conditioning system, water filtration system, a central humidifier or even a fireplace.

Improvements for the Elderly and Infirm

Declare any improvements that make your home more accessible and useful for elderly or infirm individuals, such as bathroom handrails, stair lifts or ramps.

Outdoor Improvements

Landscaping your garden increases your home’s curb appeal, an excellent way of improving market value. A new driveway, walkway, fence, retaining wall or even swimming pool are all tax deductible.

Plumbing Improvements

Plumbing additions like fitting a new water heater, installing a septic tank or attaching a soft-water filter system are considered permanent improvements to the home, according to the IRS.

Large Remodeling and Repair Projects

Painting your home and ordinary maintenance repairs are not considered capital improvements. However, the IRS may allow you to deduct them if you can prove they are part of a larger project, like remodeling a kitchen. Extensive repairs to your home after a fire, flood or other serious incident are also deductible.

Improvements to a Business

All repairs, additions and improvements to a property used in connection with a business, or one that produces income, such as a rental, are tax deductible, regardless of whether they are capital improvements. The businessperson must declare the expense as depreciation to recover the cost. It’s no secret that finishing your basement will increase your home’s value. What you may not know is that you may be eligible for tax breaks for capital improvements on your home when you sell. Tax rules let you add capital improvement expenses to the cost basis of your home. Why is that a big deal? Because a higher cost basis lowers the total profit capital gain, in IRS speak that in some cases you may be required to pay taxes on. In other words, you might have a tax benefit coming. Here’s how to know what home improvements can pay off at tax time.

The tax benefit doesn’t come into play for everyone. The large majority of home sellers will never have to pay taxes on the profits they make on their homes because of a widely available exemption on the first $250,000 of profit for single filers ($500,000 for joint filers). If you move frequently, maybe it’s not worth the effort to track capital improvement expenses. But if you plan to live in your house a long time or make lots of upgrades, saving receipts could be a smart move.

What Home Improvements Are Tax Deductible?

Some examples of eligible home improvements include:

• New bathroom

• New addition

• Basement finishing

• Master suite addition

Although you may consider all the work you do to your home an improvement, the IRS looks at things differently. A capital improvement increases your home’s value, while a non-eligible repair just returns something to its original condition. According to the IRS, capital improvements have to last for more than one year and add value to your home, prolong its life, or adapt it to new uses.

There are limitations. The improvements must still be evident when you sell. So if you put in wall-to-wall carpeting 10 years ago and then replaced it with hardwood floors five years ago, you can’t count the carpeting as a capital improvement. Repairs, like painting your house or fixing sagging gutters, don’t count. The IRS describes repairs as things that are done to maintain a home’s good condition without adding value or prolonging its life. There can be a fine line between a capital improvement and a repair. For instance, if you replace a few shingles on your roof, it’s a repair. If you replace the entire roof, it’s a capital improvement. Same goes for windows. If you replace a broken window pane, repair. Put in a new window, capital improvement.

How Capital Improvements Affect Your Gain

To figure out how improvements affect your tax bill, you first have to know your cost basis. The cost basis is the amount of money you spent to buy or build your home including all the costs you paid at the closing: fees to lawyers, survey charges, transfer taxes, and home inspection, to name a few. You should be able to find all those costs on the settlement statement you received at your closing. Next, you’ll need to account for any subsequent capital improvements you made to your home. Let’s say you bought your home for $200,000 including all closing costs. That’s the initial cost basis. You then spent $25,000 to remodel your kitchen. Add those together and you get an adjusted cost basis of $225,000. Now, suppose you’ve lived in your home as your main residence for at least two out of the last five years. Any profit you make on the sale will be taxed as a long-term capital gain. You sell your home for $475,000. That means you have a capital gain of $250,000 (the $475,000 sale price minus the $225,000 cost basis). You’re single, so you get the exemption for the $250,000 profit. Here’s where it gets interesting. Had you not factored in the money you spent on the kitchen remodel, you’d be facing a tax bill on that $25,000 gain that exceeded the exemption.

By keeping receipts and adjusting your basis, you’ve saved about $3,800 in taxes based on the 15% tax rate on capital gains. Well worth taking an hour a month to organize your home improvement receipts, don’t you think?

The top cap gains rate for most home sellers is 15%. For sellers in the highest tax brackets, such as 37%, the cap gains rate is 20%. Some situations can lower your tax basis, thus increasing your risk of facing a tax bill when you sell. Consult a tax adviser. Examples include:

• If you use the actual cost method and take depreciation on a home office, you have to subtract those deductions from your basis.

• Any depreciation available to you because you rented your house works the same way.

• You also have to subtract subsidies from utility companies for making energy-related home improvements or energy-efficiency tax credits you’ve received.

• If you bought your home using the federal tax credit for first-time home buyers, you’ll have to deduct that from your basis too.

Determining Your Home’s Tax Basis

Basis is the amount your home (or other property) is worth for tax purposes. When you sell your home, your gain (profit) or loss for tax purposes is determined by subtracting its basis on the date of sale from the sales price (plus sales expenses, such as real estate commissions). The larger your basis, the smaller your profit will be, reducing your tax liability. If you sell your home for less than its basis, you’ll have a loss. However, losses incurred on the sale of a personal residence are not deductible. One confusing thing about basis is that it can change over time. When this occurs, your basis is called “adjusted basis.” To determine the amount of your basis, you begin with your starting basis and then add or subtract any required adjustments.

Cost Basis of a Property

If you’ve purchased your home, your starting point for determining the property’s basis is what you paid for it. Logically enough, this is called its cost basis. Your cost basis is the purchase price, plus certain other expenses. You use the full purchase price as your starting point, regardless of how you pay for the property with cash or a loan. If you buy property and take over an existing mortgage, you use the amount you pay for the property, plus the amount that still must be paid on the mortgage. Certain fees and other expenses you pay when buying a home are added to your basis in the property. Most of these costs should be listed on the closing statement you receive after escrow on your property closes. However, some might not be listed there, so be sure to check your records to see if you’ve made any other payments that should be added to your property’s basis. These include real estate taxes owed by the seller that you pay settlement fees and other costs such as title insurance.

When Cost Is Not the Property’s Basis

You cannot use cost as the starting basis for a home that you received as an inheritance or gift. The basis of property you inherit is usually the property’s fair market value at the time the owner died. Thus, if you hold on to your rental property until death, your heirs will be able to resell it and pay little or no tax the ultimate tax loophole.
Example: Victoria inherits her deceased parents’ home. The property’s fair market value (excluding the land) is $300,000 at the time of her uncle’s death. This is Victoria’s basis. She sells the property for $310,000. Her total taxable profit on the sale is only $10,000 (her profit is the sales price minus the home’s tax basis).
The basis of a home or other property you receive as a gift is its adjusted basis in the hands of the gift giver when the gift was made. If you build your home yourself, your starting basis is the cost of construction. The cost includes the cost of materials, equipment, and labor. However, you may not add the cost of your own labor to the property’s basis. Add the interest you pay on construction loans during the construction period, but deduct interest you pay before and after construction as an operating expense.

Adjusted Basis of a Property

Your basis in property is not fixed. It changes over time to reflect the true amount of your investment. This new basis is called the adjusted basis because it reflects adjustments from your starting basis.

Reductions in Basis

Your starting basis in your home must be reduced by any items that represent a return of your cost. These include:

• depreciation allowed or allowable if you used part of your home for business or rental purposes

• the amount of any insurance or other payments you receive as the result of a casualty or theft loss

• gain you posed from the sale of a previous home

• any deductible casualty loss not covered by insurance, and

• any amount you receive for granting an easement.

Increases in Basis

You must increase the basis of any property by:

• the cost of any additions or improvements

• amounts spent to restore property after it is damaged or lost due to theft, fire, flood, storm, or other casualty

• tax credits you received after 2005 for home energy improvements

• the cost of extending utility service lines to the property, and

• legal fees relating to the property, such as the cost of defending and perfecting title.

In addition, assessments for items that tend to increase the value of your property, such as streets and sidewalks, must be added to its basis. For example, if your city installs curbing on the street in front of your rental house, and assesses you for the cost, you must add the assessment to the basis of your property. The most common way homeowners increase their basis is to make home improvements. Improvements include any work done that adds to the value of your home, increases its useful life, or adapts it to new uses. These include room additions, new bathrooms, decks, fencing, landscaping, wiring upgrades, walkways, driveway, kitchen upgrades, plumbing upgrades, new roofs. However, adjusted basis does not include the cost of improvements that were later removed from the home. For example, if you installed a new chain-link fence 15 years ago and then replaced it with a redwood fence, the cost of the old fence is no longer part of your home’s adjusted basis.

Example: Jane purchased her home for $200,000 and sold it ten years later for $300,000. While she owned the home, she made $50,000 worth of improvements, including a new bathroom and kitchen. These increased her basis to $250,000. She also received $10,000 in insurance payments one year to reimburse her for storm damage to the house. This payment decreased her basis to $240,000. She subtracts her $240,000 adjusted basis from the $300,000 sales price to determine her gain from the sale—$60,000.

Capital Gains Tax When You Sell Your House at Divorce

Whether and how the capital gains tax affects you during your divorce depends on what you are doing with the house. In general, transfers of property between divorcing spouses are nontaxable. But there are circumstances where the capital gains tax—a tax on profits from sales of property where the gains exceed a certain amount—does apply to transfers that are made as part of your divorce.

If You Sell Together

If you and your spouse sell your house at the time you’re getting divorced, the capital gains tax applies. But you’re entitled to exclude a total of $500,000 of gain from tax if you lived there for two of the five years before the sale. (If either spouse is in the military that five-year period can be extended for up to ten years under some circumstances.) And if you bought the house less than two years ago the exclusion may be reduced.

Buyouts

After a buyout, the selling spouse doesn’t need to worry about capital gains tax because the sale was part of the divorce. But if you buy out your spouse, stay in the house, and later sell the house to a third party, capital gains tax will apply to that sale. You may exclude the first $250,000 of gain as long as you’ve lived there for two years before selling, or meet one of the IRS exceptions to that rule.

Co-Owning the House

For a spouse who continues to own the house but doesn’t live in it, there’s a risk that the $250,000 exclusion might not apply when the house is sold. To avoid losing the exclusion, it’s important to have written documentation of the agreement that called for one spouse to stay in the house and the other to leave but remain a co-owner. If it’s clear that the arrangement was pursuant to a divorce settlement or court order, then the nonresident spouse can still take the exclusion on the basis of the resident Capital gains can be confusing. If you have questions about your basis, whether your gain is over the exclusion amount, or other aspects of capital gains taxes, try looking for the answer in IRS Publication 523, Selling Your Home, or ask your attorney or tax preparer to help you figure it out.

How to Qualify for Home Sale Tax Breaks

There are basic requirements you must meet to qualify for a tax break. Here’s a breakdown of them:

• You must have owned the home you are selling for at least two years. If you’ve owned the home for less time, you do not qualify for the tax break.

• You must have used the home as your primary residence for at least two of the past five years. This means that second homes, such as vacation homes and pure rental properties, will likely not qualify for this tax break.

• You must not have used this tax break for the sale of another home within the past two years. This means that if you are trying to sell multiple properties, the tax break can only apply to one of your properties.

Qualifying for a Reduced Home Sale Exclusion

A reduced exclusion allows you to claim part of the tax break, even if you don’t meet all of the above requirements. If you have only lived in your home for one year, for instance, you could be exempt for just $125,000 of any profit you make from selling your home. You must have a valid reason to qualify for a reduced exclusion, though. Valid reasons include changes in employment, changes in health or any other unforeseen circumstance that makes it necessary for you to sell your home sooner than anticipated.

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Michael R. Anderson, JD

Ascent Law LLC
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States

Telephone: (801) 676-5506
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