In real estate, the most attractive properties are typically the most updated ones.
So, as a property manager or landlord, you may be interested in doing some renovations or upgrades to your property.
Luckily, there is a way for property managers to make these renovations that not only bring up the value of your home but are tax-deductible.
These upgrades are called capital improvements.
If you have never heard of capital improvements, that's no problem. In this guide, we will be going over everything there is to know about capital improvements.
To begin, let's go over its general definition and some examples.
What Are Capital Improvements?
A capital improvement is any permanent improvements or alterations that are made to a property with the intent to raise its value. This could be for many reasons, like extending the life of the property or simply to suit other needs.
A capital improvement project is a great way to to make improvements to your home or rental property and benefit from it. These capital improvement projects can also lower tax payments since they are typically sales tax-exempt.
They can even help homeowners avoid the capital gains tax when selling their property!
Some examples of capital improvements include:
- Additions to the property (decks, pools, patios, etc.)
- New HVAC system
- New plumbing
- Renovating an entire room
Now, although that sounds like a wonderful idea, it is important to know that there are some regulations that come with it.
Below, we will be going over some of the things that are important to know about capital improvements and capital expenditures before starting renovations.
Special Considerations
When discussing capital improvements it's extremely important to know about all of the special considerations that come with it. In this section, we will be going over some of these considerations and expenses in detail.
Cost Basis
The first thing that must be considered before every capital improvement plan is the cost basis. The cost basis of a property is defined as the original value of an investment or an asset for tax purposes.
This metric is primarily used to calculate the capital gains or losses when a rental property is sold. Now, how does that relate to capital improvements?
The IRS sets very specific standards when it comes to allowing a renovation or improvement to increase the cost basis. There are two main concerns when it comes to allowing this:
- The renovation must have been made before the property was sold
- The renovations made must have become part of the property, to the point where removing it would decrease the value or useful life of the underlying property
The IRS also does not allow repair and routine maintenance to be considered. However, repairs that are not considered routine maintenance, like major constructions, can be considered.
Some examples of repairs that are not considered capital repair/improvements and are simply maintenance expenses include:
- Fixing leaky pipes
- Small new or replacement components
- Replacing parts of hardware
- Any minor property incidental repair
…and other minor things.
Capital Gains
As mentioned before, capita repair improvements can have an impact on the cost basis of a property, which in turn affects the capital gains. The term capital gain refers to the increase in value of any capital asset when it is sold.
Again, how does this relate to capital improvements?
Well, as mentioned above, when capital improvements are approved, they are increasing the cost basis of a property and lowering the taxable capital gain. Now, this may not sound like a big deal, but capital gains from real estate work differently than other types of investments.
For example, property owners, including large scale property owners, are eligible for a capital gains tax exemption on any profit up to $250,000 if the owner is single and $500,000 if the owner is married and filing jointly. The homeowner must have also claimed residence in that same property for at least 2 of the last years before it was sold.
So, this means that capital improvements may cause homeowners to go over this limit, and be obligated to pay their capital gains taxes.
Now that we know all about what capital improvements and some of the things tat can affect them, let's make everything a bit clearer with an example.
Capital Improvement Example
In order to fully understand what capital improvements are, we have provided a simple example here.
Let's imagine that a person purchases a home for $500,000. Then, after some time living there, they want to renovate a bathroom. Renovating a bathroom isn't cheap, so they spend $10,000 on the entire project.
Since this is qualified capital improvement and not a normal maintenance expense, this falls under the standards of capital projects, so no sales taxes are paid. Also, being a capital improvement, the cost basis of the property increases from $500,000 to $510,000.
Then, after more time of living in the property with the renovated bathroom, the property owner decides to sell the property for $750,000. Since the property had some capital improvements, the capital gain comes to $240,000. This is ideal for the homeowner because, being a single tax-payer, they do not have to pay any capital gains tax.
Hopefully this example has served to clarify any questions about capital improvements. However, we have answered some other questions that you may have right below.
Capital Improvement FAQs
Below are some of the most common questions surrounding capital improvements and our answer to them.
What Are Capital Improvement Plans?
A capital improvement plan is any community or municipal project that sets out the plans for capital improvement over many years.
These plans typically list many things about the project, like funding, expenses, land, buildings, and anything is that is relevant to the project.
What Is A Capital Improvement Fee?
A capital improvement fee is a fee that is charged by a Homeowner's Association when any property in an HOA is sold.
The amount of the fee can vary depending on the specific association. These fees are typically used to fund future capital improvements within the HOA itself.
How Do I Use A Certificate Of Capital Improvement?
A certificate of capital improvement is a document that certifies that a certain project is in fact considered a capital improvement.
This certificate is given by the property owner to the construction manager or contractor and is used to indicate that there will be no sales tax due.
