What Improvements Are Allowed for Capital Gains Tax?

Keeping your rental property competitive and well-maintained often requires major upgrades or renovations. Over time, you'll likely need to remodel areas like the kitchen or bathrooms, replace major systems like the HVAC, or add desirable features like a pool.

These improvement projects can be costly, but they also impact your capital gains tax situation when selling the property. Understanding which improvement costs you can use to adjust your property's cost basis is beneficial for real estate investors looking to minimize taxes.

In this guide, we'll cover everything you need to know about which capital improvements can reduce your taxable gains. We'll also discuss scenarios involving properties that you house-hack and use as your residence part-time. Homeowners making improvements to their primary residence can also find value in understanding these regulations.

If you own a single rental unit or a large real estate portfolio, understanding deductible capital improvements will help keep you from overpaying on taxes when selling.

Defining capital gains

Any time you sell an asset for more than you paid for it, you'll have a capital gains tax obligation. This applies to stocks, bonds, and property transactions. The good news for real estate investors is that you can deduct certain improvement costs to reduce your tax basis, lowering the gains subject to taxes.

A few other areas to note relating to this tax liability:

• Lower rates: Rates for these taxes are typically lower than regular income tax rates. For instance, while ordinary income can be taxed at rates as high as 37% depending on your tax bracket, long-term capital gains tax rates are generally 0%, 15%, or 20%, also depending on your income level.
• Strategic selling: These rates can influence decisions on when to sell an asset. Holding an asset long enough to qualify for long-term tax rates rather than short-term (equivalent to ordinary income rates) can significantly reduce the tax paid on profits.

Understanding capital improvement

A capital improvement expense is a major upgrade or addition to a property that enhances its value, adapts it for new uses, and prolongs its useful life.

These improvements are significant investments. They're different from regular repairs or maintenance, which are smaller-scale fixes to keep the property in good working order.

What do capital improvements mean for your taxes?

Capital improvements are not immediately deductible from your taxable income. Instead, they add to the cost basis of your property, which is the initial amount you paid for the home, plus any additional costs like closing costs and fees.

Since these improvements increase your cost basis, they lower the capital gains taxes you'll owe when you sell your property in the future.

Let's look at an example to show the impact on your taxes:

• Purchase price of property: You bought a property for $300,000.
• Capital improvement: Over time, you spent $50,000 renovating the kitchen for all materials, labor, and applicable sales tax.
• Adjusted cost basis: The renovation increases your total cost basis to $350,000 (the original $300,000 + $50,000 for renovation).

Now, suppose you sell the property:

• Sales price: You sell the home for $450,000.
• Capital gain with improvement: The capital gain calculation is $100,000 ($450,000 - $350,000).

Without the kitchen renovation:

• Capital gain without improvement: The capital gain would have been $150,000 ($450,000 - $300,000).

By including the kitchen renovation cost in your calculations, you reduce the amount on which you have to pay capital gains tax when you sell the property.

8 tax-deductible home improvements

The Internal Revenue Service (IRS) has guidelines listed in Publication 523 on which home improvements are considered capital improvements. Investments in your rental property can help you be competitive in the market, command higher rental rates, and increase overall home value.

Here are some common renovations and improvements that the IRS considers capital expenses:

1. Kitchen remodels

A kitchen remodel can enhance your property by modernizing the space and making it more functional and attractive. This update often leads to a perceived increase in the quality of living, making the property more desirable to prospective tenants.

2. Window replacement

 Replacing outdated windows with new, energy-efficient models can reduce heating and cooling costs and improve tenant comfort. This upgrade can also lead to lower maintenance costs over time.

3. New wall-to-wall carpeting

Upgrading the carpeting can freshen up the space and reduce noise levels. New carpets also contribute to a cleaner and more modern look, potentially increasing the rental value.

4. Swimming pool installation

If you're planning to rent out your property as a vacation rental in a warm climate, adding a swimming pool could be essential to remain competitive. This home improvement feature matches the standard set by others and enhances the attractiveness of your property.

5. Home additions or expansions

One strategy for creating forced appreciation is adding extra rooms or expanding living spaces. This adjustment can increase the property's functionality and size, allowing you to command higher rents and enhance its overall market value.

6. New roof installation

Installing a new roof is a home improvement project that enhances structural integrity and prevents issues such as leaks and water damage. This expense can extend the property’s lifespan and reduce the need for frequent repairs, leading to long-term cost savings.

7. HVAC system upgrades

A new HVAC system provides more efficient heating and cooling, lowering energy costs and improving indoor air quality. Modern systems are also typically quieter and more reliable, reducing the frequency and cost of maintenance calls.

8. Landscaping improvements

Improving landscaping increases curb appeal and creates a welcoming environment. Outdoor spaces can also increase the usable area for tenants, potentially making the property more attractive in the market.

Capital gains tax for mixed-use properties

For rental property owners, the tax rules can get tricky if you used the property as a personal residence and for business/rental purposes, which the IRS refers to as a mixed-use property.

If you rented out part of a property you also lived in, the tax treatment of any capital gains when you sell depends on whether that rental space was inside your actual living area or a completely separate unit.

It also matters how the property was utilized over the 5 years leading up to the sale:

Space within the living area

If you rented out part of your home, like a spare bedroom, you don't have to separate the capital gains between the rental portion and your living space when selling the property.

However, there is one exception — you cannot exclude any portion of the gains from capital gains equal to the depreciation you claimed for that rental space. That depreciated amount has to be recaptured and taxed as regular income instead of the lower capital gains rate.

Space separate from the living area

If you had a separate rental unit on your property, like a guest house or apartment, you generally cannot exclude the capital gains on that rental portion from taxes when you sell the property.

There is an exception, though. If you lived in that rental space as your main home for at least two of the five years before you sell it, you might not have to pay taxes on the profit from that part of the property.

Minimize the capital gains tax when selling a house

Even though capital improvements reduce your tax obligation, there are other strategies you can use to minimize your tax burden. Note that these tax strategies apply to your primary residence and not to rental properties.

1. Exclude some gains

One of the most effective ways to minimize taxes when selling your home is to take advantage of the capital gains exclusion.

If you owned and lived in the house as your primary residence for at least two of the five years prior to selling, you may be eligible for this tax break. If you're single, you can exclude up to $250,000 of the profits from taxes, or up to $500,000 if you're a married couple and filing jointly.

This exclusion allows you to keep a large portion of your profits tax-free. It's important to note that you can only claim this exclusion once every two years. There are also specific rules and exceptions that apply, so work with a tax professional to verify compliance.

2. Partial gain exclusion

If you didn't live in the home as your main residence for the full 2 out of 5 years, you may still be able to exclude some of your profits. The amount you can exclude depends on how long you actually lived there during that 5-year period.

For example, if you lived in the home for 1 year out of the 5-year period, you may be able to exclude up to $125,000 of your profits from taxes if you're single or $250,000 if married filing jointly.

3. Selling costs

Home sellers incur expenses at the time of the sale. You can deduct these costs from the sale price, lowering the total taxable profit and reducing your capital gain.

Common selling costs that are tax-deductible include:

• Real estate agent commissions.
• Transfer taxes and recording fees.
• Settlement or escrow fees.
• Advertising and marketing.
• Home staging costs.
• Legal fees.
• Seller-paid points or loan charges.
• Appraisal fees.

Non-deductible selling expenses

While some expenses related to selling your home can be deducted, there are certain costs that you cannot write off when calculating your capital gain.

Home repair costs

You cannot deduct any expenses for regular repairs and maintenance work done to keep the property in good condition from your capital gain. This includes things like fixing a leaking faucet or patching holes in the drywall. The IRS considers these costs of maintaining your property while you own it, not costs related to the sale on which you pay tax.

Expenses for moving

You cannot deduct expenses for physically moving you and your belongings to a new home from your capital gain. This includes costs like hiring movers, renting a truck, and buying packing materials. These are considered personal living costs, not costs directly related to selling your home property.

What improvements can be deducted from capital gains?

Making improvements to your property is an investment in its long-term value and appeal. The upfront costs can be substantial, but knowing how to account for these capital improvements can provide a significant tax benefit down the line.

Adjusting your cost basis with qualified improvement expenses helps reduce your taxable capital gains when you eventually sell the property. This strategy allows you to keep more of your profits in your pocket.

Whether this is your first rental property or one of many investments, staying on top of capital improvement deductions is wise financial planning. With the right documentation and knowledge, you can leverage the tax code to your advantage as a real estate investor.

Capital improvements FAQs

Can I deduct home improvements from capital gains?

Yes, you can deduct qualifying home improvement costs from capital gains when selling your home. These costs add to the home's cost basis, which reduces the taxable gain.

How do I deduct home improvements from capital gains tax?

Keep records of qualifying expenses to deduct home improvements. When selling, calculate your home's adjusted cost basis by adding the purchase price and improvement costs, then subtracting depreciation and losses. Subtract this adjusted basis from the sale price to determine your capital gain.

What is the difference between repairs and capital improvements?

The main difference between repairs and capital improvements lies in their impact on the value of your home. Repairs are fixes to maintain the home's current condition, while capital improvements, on the other hand, enhance the value or prolong the life of the property. Repairs are usually deductible as expenses, and capital improvements are added to the home's basis and deducted from capital gains when selling.