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[Prefer to listen? You can find a podcast version of this article here: E218: What Home Improvements Increase Cost Basis (And Why You Should Care)]

Home improvements are a great way to get more out of your home. It's pretty common to want to upgrade your home by adding rooms, renovating a kitchen, or updating the carpets.

But did you know that home improvements can also reduce your taxes when you sell your home?

When you sell your home, you need to be aware of two numbers: cost basis and sale price. The sale price is pretty obvious: it is how much you sell your home for. But the cost basis is something many people don't keep track of. It's the original value of the home when you bought it.

So why is this important? Because when you sell your home, you may pay taxes on the difference.

Capital Gains Tax Basics

Calculation: Capital gains tax is calculated based on the profit you make from selling your home. It's the difference between the sale price (minus selling expenses) and your adjusted cost basis, which includes the original purchase price, certain closing costs, and any qualifying home improvements.

Tax Rates: Capital gains are categorized into two types: short-term gains (for properties owned for one year or less) and long-term gains (for properties owned for more than one year). Long-term capital gains are typically taxed at lower rates than short-term gains.

Exclusion Amounts for Primary Residences

Primary Residence Exclusion: The IRS provides a significant tax benefit for homeowners selling their primary residence. As of this publish date, up to $250,000 in capital gains can be excluded from taxation for single filers. The exclusion amount is doubled to $500,000 for married couples filing jointly.

Eligibility Criteria: To qualify for this exclusion, homeowners must meet certain criteria:

• The home must have been your primary residence for at least two of the past five years before the sale.
• You cannot have claimed the exclusion on another home sale within the previous two years.
• The exclusion is generally not available for properties used primarily for business or rental purposes.

For example, let's say you and your spouse bought your home for $250,000 and sold it for $600,000 after living in it as your primary residence for more than two years. Your adjusted cost basis, including qualifying improvements and closing costs, is $300,000 ($250,000 + any closing costs and home improvements). More on home improvements in a minute.

• Sale Price: $600,000
• Minus Adjusted Cost Basis: $300,000
• Capital Gain: $300,000

Since your capital gain of $300,000 falls within the $500,000 exclusion amount for married couples filing jointly, you would not owe any capital gains tax on the sale.

However, let's look at another example. Let's say you are single and bought a house for $300,000 in an up-and-coming area of town. You live in it for many years and eventually sell it for $700,000. Your adjusted basis after home improvements and closing costs is $310,000.

• Sale Price: $700,000
• Minus Adjusted Cost Basis: $310,000
• Capital Gain: $390,000

Since the exclusion for single filers is $250,000, you would pay capital gains tax on the remaining amount ($390,000 - $250,000 = $140,000).

As you can see, having a higher cost basis when selling your home can be advantageous because it can reduce the likelihood that you will pay capital gains tax.

So how do you maximize your cost basis?

Keeping track of your home improvements can be a great way to reduce capital gains tax when selling your home.

How Home Improvements Increase Your Cost Basis

Home improvements can increase your home's cost basis by adding to the original purchase price.

When you initially buy a home, the purchase price establishes the home's original cost basis. Any qualifying home improvements and renovations you complete after buying the home can be added to that original cost basis.

For example, if you bought a house for $300,000 and later spent $50,000 on a kitchen remodel, your new cost basis would be $350,000 ($300,000 original purchase price + $50,000 in improvements).

Increasing the cost basis through home improvements is beneficial because it reduces your capital gains tax liability when you eventually sell the home. The higher the cost basis, the lower the capital gain.

What Home Improvements Increase Cost Basis

So what home improvements qualify to increase the cost basis of your home?

The most important thing to understand is the difference between improvements and repairs.

Improvements refer to significant enhancements made to your home that increase its value, extend its useful life, or adapt it to new uses. These are substantial changes that go beyond routine maintenance.

While there is no specific list of every possible home improvement that qualifies for adding to the cost basis, here are some examples of home improvements:

• Adding a new room or space to the home.
• Remodeling the kitchen or bathroom.
• Installing a new roof or HVAC system.
• Adding a deck, patio, or swimming pool.
• Upgrading to energy-efficient appliances or solar panels.
• Making structural changes like adding or removing walls.

The cost of improvements is added to your home's cost basis, increasing the cost basis for tax purposes. This can lead to lower capital gains taxes when you sell the property.

Repairs are maintenance activities done to keep the home in good condition. They do not significantly increase the property's value or extend its useful life but rather address issues to maintain its existing condition.

Examples of repairs:

• Fixing a leaking roof or plumbing.
• Repairing broken fixtures or appliances.
• Patching cracks in walls or floors.
• Repainting walls or replacing worn-out carpeting.

Repairs do not increase the cost basis of your home. While necessary for upkeep, they are considered routine maintenance and do not add substantial value or longevity to the property.

Documenting Home Improvements

You'll need to document every improvement to establish the highest possible cost basis when you sell your home. Here are some ways to ensure you track everything properly:

• Keep Receipts and Invoices: Save all receipts, invoices, and contracts related to home improvements. This includes materials, labor costs, permits, and any other expenses directly associated with the improvements.
• Record Dates and Descriptions: Note the dates when improvements were made and provide detailed descriptions of the work done. This helps establish the timeline and nature of the improvements for tax purposes.
• Photographic Evidence: Photos or videos should be taken before, during, and after the improvement projects. Visual evidence can be valuable in showcasing the scope and quality of the improvements.
• Maintain Digital Copies: Create digital copies of all documentation and store them securely. Digital formats are easy to organize, access, and backup for future reference.
• Organize Documentation by Project: Organize your documentation by improvement project to make it easier to track and retrieve information when needed. Use folders or digital filing systems for each project.
• Consult with Professionals: Consider consulting with tax professionals, accountants, or real estate experts to ensure that your documentation meets IRS requirements and maximizes tax benefits.
• Retain Records for Future Sales: Keep all documentation related to home improvements for as long as you own the property and even after selling it. These records are important during tax filings and potential audits.

By maintaining detailed records of all home improvements, you can maximize your chances of increasing your adjusted costs basis as much as possible when selling your home, which can minimize the capital gains taxes you might pay.