Most people who sell their homes after making improvements don't have to worry about paying capital gains taxes on any profit they make, because the U.S. tax code includes fairly substantial exemptions for such profits. Still, there are cases in which capital gains taxes will apply -- and improvements can affect the tax you pay.
Before worrying about capital gains taxes, make sure you're actually subject to them. In general, if you have owned and lived in your home for a total of two years in the past five years, you can exclude the first $250,000 worth of profit from your home sale, or the first $500,000 if you're married and file a joint return. "Exclude" is tax talk for "avoid paying taxes on." One final wrinkle: You can exclude profits from a home sale only once every two years.
Assuming that you either don't qualify for an exclusion (sorry), or that your profit is so ginormous that it exceeds the exclusion amount (a little less sorry), it's time to figure the damage. That means getting familiar with "basis" and "gain." Basis is what you paid to acquire the house. It includes not only the purchase price but also many closing costs. It also includes money spent to make improvements to the home. The Internal Revenue Service defines an improvement as anything that adds value to your home (say, a room addition), makes the home last longer (a new roof) or adapts it for a new use (a wheelchair ramp). Basic repairs and the replacement of appliances are not improvements, although repairs of disaster damage do count.
Your gain is your profit. Start with the price you get for the house. Subtract your selling expenses, such as real estate commissions and advertising. Now subtract your basis. Finally, subtract any exclusion amount to which you're entitled. The result is your taxable gain, and if you're subject to capital gains tax, that's what you'll be taxed on. Note that, since the money you spent on improvements is included in your basis, you get to subtract those costs regardless of whether they translated into an actual increase in the amount of money you got for the home.
When it comes to improvements and capital gains taxes, all that matters is the effect on the selling price. Again, assuming that capital gains taxes apply, if an improvement increases the selling price of your house by more than the cost of the improvement itself, it will increase your gain and therefore increase your capital gains tax. But if the money you spent on the improvement doesn't all come back to you as profit when you sell, then the improvement will have actually reduced your gain and your tax. Plenty of improvements fit this scenario. A new roof might not add back its cost in value. (People expect homes to have roofs, after all.) Adding a swimming pool might not change the value of the home enough to recoup the cost, if there's little demand for homes with pools.
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