how a capital improvement works
capital improvements typically increase the market value of a property but may also expand the usefulness of the asset beyond its current state according to the internal revenue service irs a capital improvement must endure for more than one year upon its completion and be durable or permanent in nature although the scale of a capital improvement can vary both individual homeowners and large scale property owners make capital improvements irs publication 523 outlines the official definition of capital improvement examples of residential capital improvements include adding or renovating a bedroom bathroom or deck other irs approved projects include adding new built in appliances wall to wall carpeting or flooring or improvements to a home s exterior such as replacing the roof siding or storm windows installing a fixed swimming pool or driveway may also be qualified capital improvements 1the irs distinguishes between a capital improvement and a repair or replacement due to normal wear and tear for example if your refrigerator breaks after several years of service or you have leaky pipes those repairs are not capital improvements however if a person adds solar panels and a tool shed to their property both of which are affixed permanently to the property they would be considered capital improvements to the home an example of a business based capital improvement would be installing a new hvac system or putting in americans with disability act ada accessible features to an existing building similarly the creation of a new public park in a downtown area would also be considered a capital improvement for a city in these scenarios the new additions would make the respective properties more valuable would be considered permanent and their removal would cause material harm to the property most repairs do not count as capital improvements related expensesthere are several expenses to keep in mind when considering a capital improvement program for example the cost basis is the original cost of an asset the irs sets specific standards for an improvement to qualify as a cost basis increase a primary concern is it must be in place at the time a property is sold a capital improvement must also become part of the property or be affixed so permanently to the property that its removal would cause significant damage or decrease in the value of the property itself repairs or maintenance cannot be included in a property s cost basis however repairs that are part of a larger project such as replacing all of a home s windows do qualify as capital improvements renovations that are necessary to keep a home in good condition are not included if they do not add value to the asset examples of such non qualifying repairs according to the irs include painting walls fixing leaks or replacing broken hardware capital improvements can help reduce one s capital gains taxes when selling a home or building in addition to improving the home a capital improvement per the irs increases the cost basis of a structure that is expenses incurred upon making the improvements are added to the amount the owner paid to buy or build the property augmenting the cost basis in turn reduces the size of the taxable capital gain when selling the property capital gains from real estate behave differently than other types of capital gains as of 2022 homeowners are entitled to a capital gains exemption on any profit from the sale of a primary residence up to 250 000 if single and 500 000 if married and filing jointly this exemption has one important caveat the homeowner must have had a residency at the property for at least two of the last five years before the sale 2also if the gain is significantly more than those sums listed above the tax effects of a capital improvement can be significant many factors may make a taxpayer breach the 250 000 500 000 capital gains levels these include if the owners acquired the property many decades ago and if local real estate values had dramatically increased since the purchase new york state s rent laws include a provision called the major capital improvements mci program dating from the 1970s it allows landlords to raise rent stabilized or controlled building rents by up to 6 annually to recoup the cost of major capital improvements to those structures an hvac system upgrade new elevators updated common spaces and other improvements all count toward the mci in february 2019 two state legislators introduced a bill to eliminate the program charging it is too easy for building owners to abuse the program abuse comes when these unscrupulous landlords submit inflated or fabricated claims of expenses potential for fraud aside the mci program is inherently unfair claim some critics these critics argue that a capital improvement is a one time cost for a landlord but a rent increase is an ongoing expense for a tenant 3examples of capital improvementsimagine a person who purchases a home for 650 000 and spends 50 000 to renovate the kitchen and add a bathroom in many cases sales tax will not have to be paid to the contractors for this job as it is a qualified capital improvement the cost basis of the home also increases from 650 000 to 700 000 after 10 years of owning and living in the home the homeowner who is single and files taxes as such ends up selling the property for a price of 975 000 if no capital improvements had been made the taxable amount for the capital gain would normally be 75 000 975 000 sale price 650 000 purchase price 250 000 capital gains exclusion because the capital improvement increased the cost basis by 50 000 the taxable amount for the capital gain would be just 25 000 975 000 650 000 50 000 250 000 25 000 