Home equity rose sharply since 2020 for most states, up 450% in West Virginia, the biggest change in the US.
The average homeowner currently has $313,000 of equity, according to the Mortgage Monitor report.
While that number is likely skewed, we all can agree that many homeowners are sitting on large equity.
And, there likely will come a time when you have to sell your home to either move elsewhere, upgrade, or downgrade. With such large equity also comes another problem – capital gains tax.
Luckily, if you sell your primary home, you may be able to exclude up to $250,000 (or $500,000 for married filing jointly) of the gain from taxes if you meet the ownership test (own the home for at least 2 out of the 5 years) and residence (must have used the home as main residence for at least 24 months during the 5 year period).
But, in some cases, that’s not enough.
It’s not uncommon to see homes in my area (midwest) that were sold for $250,000 in the 1990s and are worth around $750,000 now. In other “hotter” areas, that appreciation is even steeper.
This brings me to my main point of this newsletter – home improvements.
Most of the stuff you buy for your house is not deductible. You can’t get any tax deductions.
But there are some improvements that you can do that will increase the home’s basis.
This means that when you eventually sell the home, you could pay less capital gains tax. Let me give you an example of before and after with improvements tracking:
Before:
Say Jonathan bought a house for $250,000 (cost basis). Sold for $750,000 (assume no closing costs for simplicity). He is single.
Total proceeds: $750,000
Cost basis: $250,000
Capital gains exclusion: $250,000
Capital gains tax: $750,000 – $500,000 = $250,000
After:
Say Jonathan bought a house for $250,000 (cost basis). Sold for $750,000 (assume no closing costs for simplicity). He is single. Over the course of him having this house, he also did $100,000 of improvements that he tracked.
Total proceeds: $750,000
Cost basis: $350,000
Capital gains exclusion: $250,000
Capital gains tax: $750,000 – $500,000 = $150,000
Jonathan can save thousands of dollars by tracking these improvements.
What is an improvement?
Improvements add to the value of your home. They prolong the useful life of your home.
As such, you can add the cost of additions and improvements to the basis of your property.
In Publication 523, here are some examples of improvements that increase basis:
- Additions (bedroom, bathroom, deck, garage, porch, patio)
- Lawn & grounds (landscaping, driveway, walkway, fence, retaining wall, swimming pool)
- Exterior (new roof, new siding, storm windows/doors, satellite dish)
- Insulation (attic, walls, floors, pipes and duct work)
- Systems (heating, central air, furnace, duct work, central humidifier, air/water filtration system, wiring upgrades, security system, lawn sprinkler system)
- Plumbing (septic system, water heater, soft water system, filtration system)
- Interior (built-in appliances, kitchen modernization, flooring, wall-to-wall carpeting, fireplace)
Some of these categories are certainly broad.
“Kitchen modernization” is an interesting one. Buying a new refrigerator wouldn’t count as kitchen modernization, but replacing entire cabinets and countertops as part of a larger project might qualify.
To give some practical examples, here are some things that would qualify:
- Putting an addition on your home
- Replacing an entire roof
- Paving your driveway
- Installing central AC
- Rewiring your home
Let’s also cover what you CAN’t include as improvements:
- Any costs of repairs or maintenance that are necessary to keep your home in a good condition but don’t add to its value or prolong its life (painting, fixing leaks, filing holes or cracks)
- Any costs that are improvements but no longer part of your home
- Any costs of improvements with a life expectancy of less than 1 year.
Basically, anything that’s cosmetic in nature and is a repair wouldn’t qualify.
Important exception – you can include repair-type work if it is done as part of an extensive remodeling or restoration job. For example, replacing broken windowpanes is a repair, but replacing the same window as part of a project to replace all the windows in your home counts as an improvement. Also, check your state rules for capital gains, as exclusions and basis adjustments may differ.
Some improvements may also qualify for tax credits, not just basis increases. In particular, solar panels and energy-efficient window upgrades, though many of these credits are being phased out soon under the OBBBA.
Records
It’s important to keep records to document the property’s adjusted basis.
Any time you buy real estate, you should keep records to document the property’s adjusted basis.
Any time you sell real estate, keep all of the records generally until 3 years after the due date for your tax return for the year in which you sold your home.
For all home improvements, I suggest keeping the following records:
- Contractor invoices/proposals
- Payments (either credit card statements, or bank account statements).
- Receipts. If you are dealing with a more established contractor, that shouldn’t be an issue. If paid via cash, ask if you can get some sort of receipt
You can also create a quick spreadsheet with amounts, dates, and descriptions. Include links to a cloud portal where you can store these documents. Just make sure to keep it secured and enable 2FA.
Tracking and documenting home improvements can save you tens of thousands in capital gains taxes when you sell your home. Even small improvements, when tracked over time, can make a big difference in your tax bill.
I hope you learned something new.
Chat next week.
MC, CPA