What is 'Capital Improvement'

A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property's overall value, increases its useful life or adapts it to a new use. This type of improvement, according to the Internal Revenue Service (IRS), is required to be any addition or improvement to a piece of property that is expected to last for longer than one year. Although the scale of the capital improvement can vary, both individual homeowners and large-scale property owners make capital improvements.

BREAKING DOWN 'Capital Improvement'

A capital improvement, as outlined by IRS Publication 523, must be an alteration to a home or property that meets all three of the following conditions:

• A capital improvement needs to substantially increase the overall value of a property. This includes the ability to appreciably prolong the life of the property.

• A capital improvement must become part of the property or must be permanently added to the property so that the removal of it would cause significant damage to the property itself.

• The intention of the improvement must be for it to become a permanent addition.

For example, if a person buys a new hot water heater and a tool shed for his property, both of which are attached to the home, they would be considered capital improvements to the house. Similarly, the creation of a new public park in a downtown area would also be considered a capital improvement for a city. In these scenarios, the new additions would make the respective properties more valuable, would be considered permanent additions, and the removal of them would cause material harm to the home and the city's property.

Capital Improvements Can Affect a Property's Cost Basis

In addition to improving the home, a capital improvement can work to increase the cost basis of a home and reduce capital gains tax when selling the property. If, for example, a person purchases a home for $150,000 and then spends $10,000 on a new bathroom, the cost basis of the home increases from $150,000 to $160,000.

In this example, after two years of owning the home, the homeowner sells the property for an price of $200,000. If no capital improvements had been made, the taxable amount for capital gains would be $50,000, derived as $200,000 - $150,000. However, since the capital improvement increased the cost basis by $10,000, the taxable amount for the capital gain would be $40,000, calculated as $200,000 - ($150,000 + $10,000).

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