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, prolongs its useful life, or adapt it to new uses. Individuals, businesses, and cities can make capital improvements to the property they own. In a business or municipal sense, this process may also be known as capital expenditures.
According to the Internal Revenue Service (IRS), to qualify, this type of improvement must endure for more than one year upon its completion. Although the scale of a capital improvement can vary, both individual homeowners and large-scale property owners make capital improvements.
- A capital improvement is a permanent structural change or restoration that enhances a property's value, increases its useful life, or adapts it for new use.
- The IRS defines capital improvements and distinguishes them from repairs.
- In addition to enhancing a home, capital improvement increases the cost basis of that home, which in turn reduces the size of any taxable profit when it is sold.
How a Capital Improvement Works
Capital improvement typically increases the market value of a property but may also expand the usefulness of the asset beyond its current state.
IRS Publication 523 outlines the definition of a capital improvement. Examples of residential capital improvements include adding a bedroom, bathroom, or a deck. Other IRS approved projects include 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 example, if a person buys a new water heater and a tool shed for his property, both of which are attached to the house, they would be considered capital improvements to the home. An example of a business-based capital improvement would be replacing the HVAC or installing Americans with Disability Act (ADA) accessible features to an existing building.
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 property.
A cost basis is the original cost of an asset. The IRS sets specific standards for an improvement to qualify as a cost-basis increase. A primary concern is it must be in place at the time a property is sold. A capital improvement must also become part of the property—or be affixed so permanently to the property—that the removal of it would cause significant damage or decrease in the value of the property itself.
The IRS makes a distinction between capital improvements and repairs. Repairs or maintenance cannot be included in a property's cost basis. However, repairs that are part of a larger project, such as replacing all of a home's windows, do qualify as capital improvements. Renovations that are necessary to keep a home in good condition are not included if they do not add value to the asset. Examples of such non-qualifying repairs, according to the IRS, include painting walls, fixing leaks, or replacing broken hardware.
In addition to improving the home, a capital improvement—per the IRS—increases the cost basis of a structure. That is, expenses incurred upon making the improvements are added to the amount the owner paid to buy or build the property. Augmenting the cost basis, in turn, reduces the size of the taxable capital gain when selling the property.
Capital gains from real estate behave differently than do other types of capital gains. As of 2019, homeowners are entitled to a capital gains exemption on any profit from the sale of a primary residence up to $250,000 if single and $500,000 if married and filing jointly. This exemption has one important caveat. The homeowner must have had a residency at the property for at least two of the last five years before the sale.
Also, if the gain is significantly more than those sums listed above capital improvements' effect on the cost basis can be significant. Many factors may make a taxpayer breach the $250/500 capital gains levels. These include if the owners acquired the property many decades ago and if local real estate values had dramatically increased since the purchase.
Assume, for example, a person purchases a home for $650,000 and spends $50,000 to renovate the kitchen and add a bathroom. The cost basis of the home increases from $650,000 to $700,000. After 10 years of owning and living in the home, the homeowner, who is single and files 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 be $75,000 ($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 ($975,000 - ($650,000 + $50,000) - $250,000 = $25,000).
Example of a Capital Improvement
New York State's rent laws include a provision called the Major Capital Improvements (MCI) program. Dating from the 1970s, it allows landlords to raise rent-stabilized or -controlled building rents by up to 6% annually, to recoup the cost of major capital improvements to those structures. An HVAC system upgrade, new elevators, updated common spaces, and other improvements all count toward the MCI.
In February 2019, two State Legislature members introduced a bill to eliminate the program, charging it is too easy for building owners to abuse the program. Abuse comes when these unscrupulous landlords submit inflated or fabricated claims of expenses. Potential for fraud aside, the MCI program is inherently unfair, claim some critics. These distractors say a capital improvement is a one-time cost for a landlord, but a rent increase is an ongoing expense for a tenant.