If the value of your home has appreciated significantly since you purchased it, you may owe taxes on the sales proceeds. One way to reduce this tax liability is to add the money spent on capital improvement projects to your original purchase price. Before you can do so, however, you must understand what types of costs the tax law accepts as capital improvements and under what circumstances they are deductible.
Practically all income is subject to income tax, and the gain from the sale of your house is no exception. If you sell your home for more than you paid, the profit is considered income. Fortunately, this income is exempt from taxation for up to $250,000 for single filers and $500,000 for couples who file jointly. If, however, you have purchased your home a very long time ago, and house prices advanced sharply since then, the sale of even a modest house can bring in more profit than these figures. In that case, the amount exceeding $250,000 or $500,000 is subject to income tax.
When calculating the net income from the sale of your house, the taxman will deduct the cost basis of your home from the net sales proceeds after taxes, fees and commissions. The cost basis is the purchase price plus the cost of all applicable capital improvements to your house. The tax law contains precise provisions about what types of projects constitute capital improvements and distinguishes these from repairs.
A investment constitutes a capital improvement if it enhances the property over and above its original condition. Any work that merely restores the house to its original state is considered a repair. Adding a garage to your backyard is a capital improvement; fixing the roof of a garage that was there when you purchased the house is a repair. Likewise, repainting any part of the house or fixing what is broken is a repair, while adding a permanent appliance such as a washing machine or air conditioning unit that becomes part of the property and will be transferred to the next owner is considered a capital improvement.
Whenever you make capital improvements, keep all receipts and take detailed notes about what exactly has been done. Whenever possible, take before-and-after pictures that clearly detail the nature of the work. To qualify as a capital improvement, the addition to your house must be passed over to the next owner. So if you decide to remove the wall-mounted air conditioner before you sell the house, or if the hardwood floors fall into disrepair and you replace them with carpets, the cost of these additions cannot count as capital improvements. It is, therefore, also a good idea to take pictures of the interior as well as exterior of your home immediately before the sale, so you can keep track of and later prove what improvements have been passed on to the next owner.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.