A capital improvement is any permanent addition or alteration that adds to the value of your home or adapts your home to a different use. Whether these improvements are made to your primary residence or to a rental property you own, you may be eligible for certain tax deductions and benefits.
What is a capital improvement?
A capital improvement, as defined by the IRS, is a change made to property you own that does at least one of the following:
- Add to the value of the property
- Prolong the property’s life
- Adapts the home to new uses
To be considered a capital improvement and qualify for a tax break, the IRS also states that any changes must have a life expectancy of more than one year.
What do capital improvements mean for your taxes?
When you make a capital improvement, the amount of the expense is added to your home’s cost basis — essentially what you paid for the home plus the cost of any capital improvements. The cost basis becomes important when you sell the home.
You’ll subtract the cost basis from the final sale price to determine your profit and pay capital gains tax on that profit.
For example: Say you bought your home for $150,000 and made a slew of capital improvements totaling $50,000. Now, your cost basis in the home is $200,000.
When you sell, you find that your home has increased in value and you manage to get $450,000 for the house. Your profit, after subtracting the cost basis, amounts to $250,000.
The IRS allows single filers to exclude up to $250,000 in capital gains from the sale of a primary residence. In the example above, you would avoid paying a capital gains tax on your profit. Even on rental properties, an increased cost basis due to capital improvements can help you reduce your capital gains taxes.
Finally, if you use certain types of loans to make improvements, you might be able to claim the interest you pay for home improvements as a deduction on your taxes.
Find out: Mortgage Refinance Tax Deductions Every Homeowner Should Know
Capital improvements vs. routine repairs
It’s important to note the difference between a necessary repair and a capital improvement. In general, a repair is something that you would do to maintain the home at a basic level.
On the other hand, a capital improvement is something that adds to the value of the home or increases its usefulness.
For example:
Fixing your rain gutter or painting a bedroom is considered a repair. Finishing your basement or installing a new HVAC system is considered a capital improvement.
However, things are a little different when you’re a rental property owner. As a rental property owner, you can deduct the cost of a repair on your taxes each year. However, a capital improvement should be capitalized and included in the cost basis for later.
To give you a better idea of what qualifies as a capital improvement, check out the table below:
When repairs turn into capital improvements
In some cases, it can be difficult to figure out whether a home improvement project counts as a repair or a capital improvement.
One example the IRS gives is replacing a window. Replacing one or two windows is a repair. However, if you’re replacing them as part of a larger project — such as to improve energy efficiency in the home — these repairs can qualify as a capital improvement.
Good to know: The IRS counts repairs designed to bring your home into its condition before experiencing some sort of casualty, such as a burglary or natural disaster, as capital improvements.
For the most part, if a project is large enough to add value to your home or upgrade its use, you can generally consider it a capital improvement. If you’re not sure, consult with a tax professional to get an idea of what you can include.
Learn More: Should You Refinance to Pay for Home Improvements?
5 capital improvements to consider
As a homeowner, you’re likely to consider capital improvements that both enhance the value of your home and make it more useful. Here are five improvements that can enhance your home — and potentially raise its value.
Window replacement
If you want to replace your windows for energy efficiency or upgrade to storm windows, you can expect to spend, on average, about $650 per window. Replacing windows on a three-bedroom house can cost between $3,000 and $10,000, depending on the types of windows used and whether you hire a contractor to complete the project.
While the upfront cost might be somewhat pricey, you’ll save on energy costs and add plenty of value to your home. According to a HomeLight survey, homeowners who replaced all of the windows in their homes recouped an estimated 81% of their investment.
Kitchen modernization
Upgrading your kitchen with new cabinets, adding new appliances, and even replacing flooring or adding counter space can increase the value of your home.
Plus, modernization can make the home more useful and desirable to buyers. You can expect to pay, on average, between $13,360 and $37,727 for a typical kitchen remodel.
Wall-to-wall carpet
Adding wall-to-wall carpeting, or replacing the carpet in your home, can be considered a capital improvement. However, it’s important to note that a previous replacement won’t be added to your basis. Only the replacement in your home when you sell can be considered a capital improvement.
Depending on the materials and labor, carpet installation can cost between $756 and $2,589 or more.
Swimming pool
If you want a swimming pool, adding one can be considered a capital improvement, particularly an inground pool. The average cost of installing an inground pool is $51,892, with costs likely to range between $38,705 to $69,632.
A pool can add substantial value to a home if you live in a warm climate.
Building a fence around your yard
Depending on the material you use (vinyl versus wood, for example), as well as the height of the fence, you could spend quite a lot on fencing. The national average cost for fencing a yard is $1,800, although the average yard could cost up to $3,000 or more for fencing.
Despite the cost, a new fence can provide a layer of security and privacy — and it has the potential to increase your home’s value too.
See: 18 Home Improvement Projects You Can Wrap Up in a Day
How to pay for capital improvements
You have several options when it comes to paying for capital improvements. Because these improvements are expected to increase the value of your house, you might be able to find good terms for financing when you use home improvement loans, for example.
Check out some of the other alternatives available to you below.
Cash-out refinance
With a cash-out refinance, you’ll pay off your existing mortgage and take out a new mortgage with a higher loan amount than what you owe on the home. The extra cash you get as a result provides you with a chunk of capital that can be used to make home improvements.
Just make sure you understand the tax implications of a cash-out refinance before you move forward.
Credible can help you get started with your cash-out refinance. You can compare our partner lenders and get prequalified refinance rates without leaving our platform — it’s simple and only takes a few minutes.
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Personal loan
A personal loan is an unsecured loan that you can use to pay for capital improvements. You don’t have to worry about how much equity is available in your home, and the loan isn’t secured by your house, so you don’t have to worry about losing your property if you can’t make payments.
Home equity loan
With a home equity loan, you receive a lump sum based on how much equity you have in your home. You have a set payment and schedule, and if you want more funds you have to apply for another loan.
It’s important to note that this loan is secured by your home, meaning your lender can foreclose on your home if you fall behind on your scheduled payments.
HELOC
Like a home equity loan, a home equity line of credit (HELOC) is based on how much equity is available in your home. However, instead of being issued a lump sum, a HELOC provides you a line of credit — similar to a credit card — that you can draw on for a specific amount of time.
You can get cash as needed to make improvements without reapplying for a loan, and you’ll only pay interest on the amount that you borrow.
Credit card
It’s also possible to fund smaller capital improvements, such as water heater installation, with a credit card. You won’t secure the debt with your home, and how much you receive isn’t based on your home’s equity.
