One of the more controversial aspects of the tax code in the United States is that it effectively incentivizes homeownership. For starters, homebuyers may be able to deduct the mortgage interest on their primary residences and loans for capital improvements, up to certain levels, as well as their property taxes. (From a practical standpoint, many taxpayers can’t take advantage of these deductions because they’re not itemizing deductions on their tax returns.) Additionally, homeowners are able to exclude a share of their profits when they sell their primary residences: $250,000 in home-price appreciation is excludable by single filers and double that amount for married couples filing jointly. (Investment properties don’t qualify for the exclusion, and the homeowner must have lived in the home for two of the past five years.)
The trouble is, those exclusion amounts haven’t been updated since they were signed into law in 1997. Meanwhile, average home prices have more than doubled over that stretch, and they’ve seen much greater appreciation in many markets, especially along the coasts and in the Sunbelt. As a result, homeowners who have lived in their residences for a long time and/or who reside in areas that have enjoyed substantial home-price appreciation may find themselves on the hook for capital gains taxes when they sell because their profits exceed the exclusion amounts.
The good news is that there’s a way to reduce the tax burden: Find and document the home improvements that you’ve made over your holding period. Doing so effectively lifts your cost basis in the home, thereby reducing the spread between your cost basis (original home price plus improvements and any additional costs you paid, such as attorney fees and inspections) and the price of the home at the time that you sell.
The concept of basis will be familiar to most investors, who are accustomed to seeing their cost basis in securities adjusted to reflect reinvested dividend and capital gains distributions. However, in contrast with your brokerage account, where your investment provider is required to track your cost basis for you, tracking cost basis on your home is a much more manual process. It may be a psychologically difficult one, too, in that homeowners might be inclined to downplay the outlays they’ve made to improve their homes.
How Home-Sale Taxes Work
To use a simple example of how the taxes on home sales work, let’s assume a couple sells their primary residence after occupying the home for a decade. Let’s further assume they paid $300,000 for the home and they’re selling it for $750,000. In that case, their profit is $450,000, a figure that escapes capital gains tax because it’s less than the $500,000 exclusion amount for couples.
On the other hand, if they sold that same home, which they purchased in 2013 for $300,000, for $1 million, they’d owe capital gains on $200,000 of their $700,000 in profit. (The $200,000 is the amount of profit in excess of their $500,000 exclusion.) If they’re in the 15% tax bracket for capital gains, their tax bill would be $30,000 on the sale: 15% of their $200,000 gain.
That’s not the worst thing in the world; they’ve made a tidy profit, after all. But if they’ve made capital improvements to the home (details on what qualifies below), they can increase their cost basis by the amount they’ve sunk into those improvements. In other words, the increase in cost basis helps ensure that they’re not paying taxes on the portion of their gain that was their own money. To get back to the example, let’s assume that the above-mentioned couple sells their primary residence, purchased for $300,000, for $1 million but also had put $150,000 into building an addition on the home while they lived there. In that instance, they’ll still owe taxes on the sale but much less than if they didn’t make the improvement. Assuming a 15% tax rate for capital gains, they’d owe $7,500, or 15% of their $50,000 gain in excess of the $500,000 exclusion amount and their additional $150,000 in capital improvements.
The Fine Print
But it’s also important to understand that not each and every house-related outlay can help increase cost basis. The IRS makes a distinction between what counts as a capital improvement—an outlay for a change that adds to the value of the property, extends its useful life, or adapts it to new uses—and what’s simply a minor repair or home maintenance. The former outlays can be used to increase cost basis, while the latter have no impact.
Common home improvements that qualify as capital improvements include home additions; new siding, doors, roofs, and windows; and new HVAC systems. (IRS Publication 523 has a complete list of improvements that can be used to boost cost basis, along with a worksheet for calculating your own cost basis.) On the other hand, outlays that you need to make to keep your home in good working condition but that don’t increase the home’s value or extend its useful life don’t count—items like painting, landscaping, or replacing broken hardware, for example. In addition, expenditures for home improvements that are no longer in place—for example, appliances that you no longer have—don’t count as capital improvements that boost basis. There’s also no double-dipping on home improvements that are eligible for credits or other tax breaks in the year in which you make them (for example, adding a solar energy system).
If it’s not already obvious, documenting home improvements is a smart practice for homeowners. At a minimum, you’ll want to organize and save your home-related receipts—not for every light bulb and can of paint but for anything that qualifies as a capital improvement. I like the idea of maintaining a corresponding spreadsheet for capital improvements and keeping it updated as you go along. Such a file can also serve as a valuable repository of home-related details: when you last replaced the roof or washing machine, for example.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.