In a story on home ownership and use tests published last week, I explained how the law allows a home seller an exclusion from taxes. This time we’ll talk about how identifying an improvement or repair to your home can have an impact on taxable profit following a sale.
Exclusions from taxes apply from taxes of up to $250,000 in profit on home sales for single filers and up to $500,000 for married couples filing jointly. But a seller whose gain exceeds the exclusion cap of $250,000 or $500,000 is stuck with taxes on the excess.
If the IRS questions your sale, the examination will be less traumatic and less expensive if you’ve kept meticulous records that track your home’s basis — the figure used to determine gain or loss on a sale of the property. Those records should include what you originally paid for your home, settlement or closing costs — such as title insurance fees — and what you later shelled out for improvements, as opposed to repairs.
You can’t claim current tax deductions for your outlays, whether they’re classified as repairs or improvements. But while repairs can’t be added to the home's cost basis, improvements can.
The result: Improvements eventually lower any taxable profit on a subsequent sale.
Your expenditures qualify as improvements only if they fit within any one of three definitions. They must:
- Add to the value of your home;
- Prolong its useful life; or
- Adapt it to new uses.
Most outlays pass muster under the add-to-the-value test. The possibilities run the gamut from big projects, such as putting a recreation room in your unfinished basement, adding another bathroom or paving your driveway, to small jobs, such as upgrading closets and installing built-in bookcases, new faucets or medicine cabinets.
Basis-increasers include your payments for special tax assessments for improvements that boost the value of your home. They typically include assessments for streets, sidewalks, water mains, sewer lines and public parking facilities. Other projects that might add nothing to value could, nevertheless, prolong the home's useful life. Some examples: putting on a new roof or putting in new plumbing or wiring.
What if your spending adds little or nothing at all to the home's value or doesn’t prolong its useful life? You might still qualify under adapts-to-new-uses, the last of the three tests. For instance, you put a laundry room in your unfinished basement. The area now serves a new use.
Your home’s adjusted basis includes only the cost of permanent improvements. The basis doesn’t include any improvements that are no longer part of the home.
In calculating how much has been spent on improvements, you can include materials for do-it-yourself projects. But you can’t count the value of your own labor or any other labor for which you did not pay.
Repairs simply don’t count. It makes no difference how urgent they are. All that repairs do is "maintain your home in good condition," says the IRS. They don’t add to its value or prolong its life. Some examples: repainting your house inside or outside, fixing your gutters or floors, repairing leaks or plastering, and replacing broken window panes.
To the surprise of no one, including the IRS, its precise definitions frequently fail to answer clearly whether particular items ought to be classified as repairs or improvements. That explains why tax collectors themselves concede that there are lots of grey areas.
In their guidelines for home sellers, they note that when "items that would otherwise be considered repairs are done as part of extensive remodeling or restoration of your home, the entire job is considered an improvement."
The translation: Each situation depends on its own facts — and that can work to your advantage.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 225 and counting).
About Julian Block
Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com.