A capital improvement is money you spend that increases the value of something you own. In real estate, it can refer to anything from adding a level to your house to replacing a major component such as a roof or hot water heater. Capital improvements in owner-occupied homes reduce your capital gains tax. With rental properties, they have the same benefit while also increasing your depreciation deduction.
Types of Capital Improvements
Capital improvements are investments in your home or other property that either change its use, increase its value or extend its useful life. Adding a home office or a swimming pool changes the way that you use your property, while renovating a kitchen or bathroom should increase your home's value. Improvements that increase your home's useful life include such things as a new roof, rewiring the electrical system or replacing major mechanical systems such as furnaces or water filters.
Improving Your Home
When you sell your house, the Internal Revenue Service doesn't look at the difference between your selling price and your purchase price to calculate the profit that might be subject to capital taxes. Instead, it subtracts your adjusted basis from the amount realized -- what you sell the house for less any selling costs such as commissions and title fees. The adjusted basis is a combination of three factors: your original purchase price, your original closing costs and any money you spent on capital improvements for your house. In other words, if you put a $20,000 addition on your house, the IRS recognizes $20,000 less profit when you sell it.
Improving Your Rental Property
When you improve a rental property, the same adjustments apply to your cost basis and your taxable profit. However, you also depreciate rental properties by gradually taking a portion of their value as a write-off every year while you own them. Just as you get to depreciate the house, you can depreciate the improvements you make to it. Then again, if you're depreciating improvements, you can't claim them as repairs and write off their entire cost in the year that you do them.
Improvement or Repair
When you own your house as a residence, it's generally in your interest to consider any major work that you do to be an improvement, as improvements may reduce your taxes some day while repairs have no effect on your taxes. As a landlord, however, when the work you do falls in a gray area, it's in your interest to consider it a repair because you get more of a write-off in the present. Historically, there's a gray area between repairs and improvements -- while replacing one window in a house might be a repair, replacing every window is probably an improvement. Always consult a tax professional to be sure you're adhering to current IRS regulations.
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