What is a '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, increase its useful life or adapt it to new uses. This type of improvement, according to the Internal Revenue Service (IRS), must have a life expectancy when installed of more than one year. Although the scale of a capital improvement can vary, both individual homeowners and large-scale property owners make capital improvements.

BREAKING DOWN 'Capital Improvement'

As outlined by IRS Publication 523, a capital improvement is an improvement that adds to the value of a home, prolongs its useful life or adapts it to new uses. Such costs can be added to the cost basis of a home. Examples of capital improvements include adding a bedroom, bathroom or deck; adding new built-in appliances, wall-to-wall carpeting or flooring; or improvements to a home's exterior, such as replacing the roof, siding or storm windows. For the improvement to qualify as a cost basis increase, it must be in place at the time of sale. A capital improvement must also 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.

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 their removal would cause material harm to the home and the city's property.

Capital Improvements Versus Repairs

The IRS makes a distinction between capital improvements and repairs, which cannot be included in a property's cost basis. Repairs done as part of a larger project, such as replacing all of a home's windows, do qualify as capital improvements. Repairs that are necessary to keep a home in good condition, however, are not included if they do not add value. Examples of such non-qualifying repairs, according to the IRS, include painting, fixing leaks or replacing broken hardware.

Capital Improvements and a Property's Cost Basis

In addition to improving the home, a capital improvement (per the IRS) increases the cost basis of a home, which in turn reduces the taxable capital gain when selling the property. Capital improvement deductions are not necessary for everyone, however. As of January 2018, homeowners are entitled to a capital gains exclusion on a gain from the sale of a primary residence (up to $250,000 if single and $500,000 if married), given that the homeowner lived in that residence for at least two of the last five years before the sale.

Assume, for example, a person purchases a home for $650,000 and then spends $50,000 to renovate the kitchen and add a bathroom. The cost basis of the home, therefore, increases from $650,000 to $700,000. After 10 years of owning and living in the home, the homeowner, who is single and files his taxes as such, ends up selling the property for a price of $975,000. If no capital improvements had been made, the taxable amount for the capital gain would have been $75,000, derived as $975,000 (sale price) - $650,000 (purchase price) - $250,000 (capital gains exclusion). However, because the capital improvement increased the cost basis by $50,000, the taxable amount for the capital gain would be $25,000, calculated as $975,000 - ($650,000 + $50,000) - $250,000.

  1. Capital Addition

    Capital addition is the cost involved for adding new assets or ...
  2. Form 4797

    Form 4797 is a tax form distributed by the Internal Revenue Service ...
  3. Personal Use Property

    Personal use property is property that an individual owns for ...
  4. Property Inventory

    Property Inventory is a written tally of all of a taxpayer's personal ...
  5. IRS Publication 551 - Basis Of ...

    A document published by the Internal Revenue Service (IRS) that ...
  6. Negative Equity

    Negative equity occurs when the value of real estate property ...
Related Articles
  1. Taxes

    Tax Breaks for Second-Home Owners

    Owning a second home is a great investment for a variety of reasons, but you need to know the tax implications of multi-home ownership.
  2. Taxes

    A Tax Primer for Homeowners

    Go beyond interest and find out how mortgage points affect your taxable income.
  3. Investing

    What You Should Know About Real Estate Valuation

    Accurate real estate valuation is important to mortgage lenders, investors, insurers, and buyers and sellers of real property.
  4. Investing

    Why You Should Invest in Home Improvements

    As volatile stock prices loom following a long bull run, consumers can look to home improvements for a safe place to park their savings.
  5. Personal Finance

    7 Smart Steps Every New Homeowner Should Take

    Don't let the excitement of owning your own home lead you to make bad financial decisions.
  6. Taxes

    10 Things to Know About 1031 Exchanges

    Real estate swaps grow popular, but traps are many. Here's 10 things to know when considering 1031 swaps. Also: Beware new rules on vacation homes.
  7. Managing Wealth

    Vacation Home or Income-Producing Investment?

    There is an alternative to letting your cottage sit empty all year. But making this profit won't be easy.
  8. Taxes

    How Does a Tax-Free Exchange Work?

    In regards to the sale of property, particularly in real estate, a 1031 exchange is increasingly being recognized for its tax benefits to investors of all levels.
  9. Investing

    Buying A House Sight Unseen: Good Deal Or Bad Mistake?

    There are significant risks that need to be acknowledged before buying a home without viewing it in person.
  10. Taxes

    How To Prevent A Tax Hit When Selling A Rental Property

    Rental property ownership has its benefits but when selling you can face a big tax hit. Thankfully there are ways to reduce your capital gains exposure.
Trading Center