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HOME EQUITY ROSE sharply since 2020 for most states, up 450% in West Virginia, the biggest change in the US.
The average homeowner currently has $313,000 of equity, according to the Mortgage Monitor report.
While that number is likely skewed, we all can agree that many homeowners are sitting on large equity.
And, there likely will come a time when you have to sell your home to either move elsewhere, upgrade, or downgrade. With such large equity also comes another problem – capital gains tax.
Luckily, if you sell your primary home, you may be able to exclude up to $250,000 (or $500,000 for married filing jointly) of the gain from taxes if you meet the ownership test (own the home for at least 2 out of the 5 years) and residence (must have used the home as main residence for at least 24 months during the 5 year period).
But, in some cases, that’s not enough.
It’s not uncommon to see homes in my area (midwest) that were sold for $250,000 in the 1990s and are worth around $750,000 now. In other “hotter” areas, that appreciation is even steeper.
This brings me to my main point of this newsletter – home improvements.
Most of the stuff you buy for your house is not deductible. You can’t get any tax deductions.
But there are some improvements that you can do that will increase the home’s basis.
This means that when you eventually sell the home, you could pay less capital gains tax. Let me give you an example of before and after with improvements tracking:
Before:
Say a taxpayer bought a house for $250,000 (cost basis). Sold for $750,000 (assume no closing costs for simplicity), and is single.
Total proceeds: $750,000
Cost basis: $250,000
Capital gains exclusion: $250,000
Capital gains tax: $750,000 – $500,000 = $250,000
After:
Say a taxpayer bought a house for $250,000 (cost basis). Sold for $750,000 (assume no closing costs for simplicity), and is single. Over the course of him having this house, he also did $100,000 of improvements that he tracked.
Total proceeds: $750,000
Cost basis: $350,000
Capital gains exclusion: $250,000
Capital gains tax: $750,000 – $500,000 = $150,000
The taxpayer can save thousands of dollars by tracking these improvements.
What is an improvement?
Improvements add to the value of your home. They prolong the useful life of your home.
As such, you can add the cost of additions and improvements to the basis of your property.
In Publication 523, here are some examples of improvements that increase basis:
Some of these categories are certainly broad.
“Kitchen modernization” is an interesting one. Buying a new refrigerator wouldn’t count as kitchen modernization, but replacing entire cabinets and countertops as part of a larger project might qualify.
To give some practical examples, here are some things that would qualify:
Let’s also cover what you CAN’t include as improvements:
Basically, anything that’s cosmetic in nature and is a repair wouldn’t qualify.
Important exception – you can include repair-type work if it is done as part of an extensive remodeling or restoration job. For example, replacing broken windowpanes is a repair, but replacing the same window as part of a project to replace all the windows in your home counts as an improvement. Also, check your state rules for capital gains, as exclusions and basis adjustments may differ.
Some improvements may also qualify for tax credits, not just basis increases. In particular, solar panels and energy-efficient window upgrades, though many of these credits are being phased out soon under the OBBBA.
Records
It’s important to keep records to document the property’s adjusted basis.
Any time you buy real estate, you should keep records to document the property’s adjusted basis.
Any time you sell real estate, keep all of the records generally until 3 years after the due date for your tax return for the year in which you sold your home.
For all home improvements, I suggest keeping the following records:
You can also create a quick spreadsheet with amounts, dates, and descriptions. Include links to a cloud portal where you can store these documents. Just make sure to keep it secured and enable 2FA.
Tracking and documenting home improvements can save you tens of thousands in capital gains taxes when you sell your home. Even small improvements, when tracked over time, can make a big difference in your tax bill.
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational.
Very comprehensive. I did track all of the improvements in our condo, which was sold in 2022, and a house prior to that. There were tax benefits. I also prefer to have an awareness of the true cost of ownership. While we owned the condo we were actually travelers and lived full -time in two RVers for a few years, using a third (a class B) for transport). One of these was 41 ft and about 550 sq feet with the 5-slides extended and 1-1/2 baths). I’ve tracked the ownership and repair costs of the RVs. My budget separated costs into geographic areas.
Things change and serious health issues required that we become more stationary and in 2023 we sold the largest RV and purchased a home. I’m tracking these costs, too. Many owners in resort communities are big on decorating but have no concept or inclination for preventative maintenance. We’ve lived in such communities for more than 10 years and we are well aware of the issues and some of the unpleasant (expensive) surprises discovered by new owners. We did a more thorough inspection prior to purchase, and we’ve done some unusual, but necessary repairs. One was the ramjacking of a large, attached structure which was built on a slab. We knew the issues when we purchased and decided to stabilize it.
As a side note, in the Sonoran desert there are large areas in which the “soil” is comprised of sand and small rock. There is no bedrock. For example, in nearby Benson, ramjacking frequently requires sinking piles to 80 feet depths to achieve stability. Many homes are built on nothing.
trusting you as we did Johnathan and welcoming you to financial conversations and knowing you will honor humble dollar as special selected analyst to carry on that humble honesty
best of luck!
Excellent Article, and I did all of the above, because improvements count!
I think in the second example it is $750K -$600K=$150K. At any rate you all get the idea, it is worth it to keep excellent records, and do your best to get good info, on what counts as an improvement. Sold our house in 2022 for $725K but with improvements, got it below $500K our deduction for a married couple, and so NO capital gains tax. YAY!
Would the cost of remodeling a basement to add things like an extra bedroom, extra bath, entertainment room etc. be considered a qualified addition to the cost basis? By this I mean taking an open basement with exposed pipes, wiring and ductwork, exposed ceiling, exposed concrete walls, and a concrete floor to a finished state.
I don’t see why not.
We sold our home in 2019 after owning it for nearly 21 years. Our profit was just under $550,000 if you only looked at sale price minus purchase price. We paid our realtor nearly $40K. We also had remodeled our kitchen and upgraded our landscaping in 2018, so I had all the documentation. I did have to go through a lengthy audit process with the IRS for our 2019 return, but we ended up not owing any capital gains taxes. Keeping records is very important.
We lived in our home for 25+ years and were looking at a similar capital gain and potential IRMAA costs. Fortunately, we were able to locate most of the invoices, but it took months. Lesson learned. For our new home, I diligently keep a file of any capital improvements.
quick note: there’s a typo in your ‘After’ example.
Capital gains tax: $750,000 – $600,000 = $150,000
Also it’s not capital gains tax, it’s just capital gains.
Thanks for this timely and good post.
My wife passed away in June. I am now considering downsizing from our home of 51 years. We have done many improvements over the years but may lack sufficient documentation for many.
However, I do want to make sure I understand a few points. Since my wife was a joint owner, her share of the house would increase to FMV on the day of her death. I have a realtor’s appraisal of the house shortly afterwards as documentation. Secondly, I have 2 years to sell and take advantage of the deduction for my wife (as well as mine).
Can you confirm this and I would welcome any other advice you can offer. Thanks,
John
I wrote a short HD forum article in September 2024 about community property trusts. The comments to that article from Jonathan and Rick Conner may help you address your questions. Rick’s link to a Jeff Levine article on Kitces seems to be spot on.
Helpful article. I am in such a position having purchased a house for $159,000 in 1987 and now valued at about $900,000. We made extensive improvements as you describe over all those years nearly doubling size of the home, new baths and kitchen, etc.
But alas few receipts were kept or have been lost.
It will not matter if you and your wife pass while still owning the home, leaving it to your estate. The Angel of Death forgives all. Your heirs will inherit the home at its stepped-up basis (value at the date of your death).
You’re right, a good point, especially since we have no plans to sell. But I also just asked Connie and it turns out she has all the documentation.
Once again saved by a well organized woman.
Currently true, however the phrase Ed Slott often uses that “the tax code is written in pencil” to convey that tax laws are constantly subject to change keeps tax professionals on their toes.
I often prefer the outcome of transferring the home during life to a revocable living trust rather than having the home going through probate and thus subject to those related costs and time delays of settling your estate.
Actually our vacation home is owned by a family trust with our children as beneficiaries