Home Improvements and Your Taxes

When you make a home improvement, such as installing central air conditioning, adding a sunroom or replacing the roof, you can't deduct the cost in the year you spend the money. But if you keep track of those expenses, they may help you reduce your taxes in the year you sell your house.

Money you spend on your home breaks down into two categories, taxwise: the cost of improvements versus the cost of repairs.

You add the cost of capital improvements to your tax basis in the house. Your tax basis is the amount you'll subtract from the sales price to determine the amount of your profit. A capital improvement is something that adds value to your home, prolongs its life or adapts it to new uses.

There's no laundry list of what qualifies, but you can be sure you'll be able to add the cost of an addition to the house, a swimming pool, a new roof or a new central air-conditioning system. It's not restricted to big-ticket items, though. Adding an extra water heater counts, as does adding storm windows, an intercom, or a home security system. (Certain energy-saving home improvements can also yield tax credits at the time you make them.)

The cost of repairs, on the other hand, is not added to your basis. Fixing a gutter, painting a room or replacing a window pane are examples of repairs rather than improvements.

In the past, it was critical for homeowners to save receipts for anything that could qualify as an improvement. Every dime added to basis was a dime less that the IRS could tax when the house was sold.

But now that home-sale profits are tax-free for most owners, there's no guarantee that carefully tracking your basis will pay off.

Under current law, the first $250,000 of profit on the sale of your principal residence is tax-free ($500,000 for married couples who file joint returns) if you have owned and lived in the home for at least two of the five years leading up to the sale.

When this rule was passed into law, a lot of advisors thought it meant homeowners no longer had to track their basis. After all, how likely was it that someone would score a quarter of a million dollar profit (or a cool half a million) on their home? But even that large an exclusion may not be enough to shelter the profit in a home that you've owned for many years. So it still pays to keep good records.

To determine the size of your profit when you sell, you take everything you paid for the house, the original purchase price, fees and so on, and add to that the cost of all the improvements you have made over the years to get a grand total, which is known as the "adjusted basis." (If you sold a home prior to August 5, 1997 and took advantage of the old rule that let home seller put off the tax on their profit by "rolling" the profit over into a new home, your adjusted basis is reduced by the amount of any rolled-over profit.)

Compare the adjusted basis with the sales price you get for the house. If you've made a profit, that gain may be taxable (generally only if the profit is more than $250,000 for an individual or $500,000 for a married couple filing jointly). Unfortunately, losses on sales of personal residences are not deductible.

You can see it makes sense to keep track of whatever you spend to fix up, expand or repair your house, so you can reduce or avoid taxes when you sell.

• Make a special folder to save all your receipts and records for any improvements you make to your home.
   
• If you've lived in your house for many years, and area housing prices have been gradually going up over all those years, a portion of your gain on sale could be taxable. If so, you can reduce the taxable gain by including the improvements in the cost basis of the house.
   
• If you operate a business from your home or rent a portion of your home to someone, you may be able to write off part of your home’s adjusted basis through depreciation. If you do so, when you sell the house you can’t exclude the amount of depreciation you took under the $250,000/$500,000 gain exclusion break. Also, the cost of repairs to that portion of your home may be currently deductible.