Definition (short)
A capital improvement is a durable change to real property that increases its value, extends its useful life, or adapts it to a new use. In tax and accounting terms, it is treated as a long‑lived addition (capital expenditure, often called CAPEX) rather than an ordinary repair.
How capital improvements work (key points)
– Purpose: The work must enhance value, prolong useful life, or enable a new use for the property.
– Permanence: The improvement must be effectively permanent — typically affixed so its removal would damage the property or reduce value.
– Time test (IRS): For U.S. federal tax treatment, the project normally must provide benefit for more than one year after completion.
– Accounting/tax effect: Costs that qualify are capitalized — added to the property’s cost basis — rather than expensed as repairs. Increasing the cost basis reduces taxable capital gain when the property is later sold (subject to tax rules and exclusions).
Common examples
– Typical residential: adding or enlarging a bedroom or bathroom, installing a fixed swimming pool, replacing a roof or siding, built‑in appliances, wall‑to‑wall flooring, permanent solar panels, a new driveway.
– Typical business/civic: new HVAC system, elevators, ADA accessibility improvements, construction of a public park.
What does NOT usually qualify
– Ordinary maintenance and repairs meant only to keep property in ordinary operating condition (e.g., painting walls, fixing leaks, replacing broken hardware, routine appliance repairs) — unless those repairs are part of a larger capital project (for example, replacing all windows as part of a full‑window upgrade).
Checklist: How to decide if a cost is a capital improvement
1. Does it add value, extend life, or change the property’s use?
2. Is it permanent or affixed to the property so removal would cause damage or reduce value?
3. Will the benefit last more than one year?
4. Is the work more than routine maintenance or repair?
5. Keep contemporaneous documentation: contracts, invoices, receipts, permits, photos.
6. Record the cost in your capital asset ledger or tax cost basis records.
Step‑by‑step (basic tax treatment process)
1. Before or during the project, classify the expense (repair vs. capital).
2. Retain all invoices and proof of payment.
3. Capitalize qualifying costs: add them to the property’s cost basis (original purchase price plus allowable capital improvements).
4. On sale, compute gain = sale price − adjusted cost basis (less selling costs).
5. Apply any applicable exclusions or exemptions (for example, the U.S. primary residence exclusion rules). Consult a tax professional for your situation.
Small worked example (illustrative)
– Purchase price: $650,000
– Capital improvement: kitchen renovation costing $50,000 (permanently installed)
– Adjusted cost basis after improvement = 650,000 + 50,000 = 700,000
– Later sale price: $800,000
– Capital gain before exclusions = 800,000 − 700,000 = 100,000
Under current U.S. primary residence rules, a single homeowner can exclude up to $250,000 of gain ($500
$500,000 for married couples filing jointly.
Applied to the small worked example above:
– Adjusted cost basis after improvement = $700,000 (650,000 + 50,000).
– Sale price = $800,000; pre-exclusion gain = $100,000.
– Because that gain is less than the $250,000 single exclusion (or $500,000 joint), the seller can exclude the entire gain and owe no capital gains tax on it — assuming the ownership-and-use tests are met (see checklist below).
Key rules and formulas (compact)
– Adjusted basis = original purchase price + qualifying capital improvements − any depreciation claimed while the property was used for business or rental.
– Taxable gain on sale = sale price − selling costs − adjusted basis.
– Primary-residence exclusion (U.S.): up to $250,000 single, $500,000 married filing jointly, if you owned and lived in the home for at least 2 of the last 5 years before the sale (ownership-and-use tests). Partial exclusions or ineligibility apply in special situations (job change, health reasons, prior exclusions, nonqualified use).
Worked numeric example with depreciation (illustrative)
– Purchase price = $400,000.
– Capital improvements (permanently installed overhaul) = $60,000 → new basis before depreciation = $460,000.
– Later converted to rental for 3 years; claimed straight-line depreciation total = $30,000.
– Adjusted basis at sale = 460,000 − 30,000 = 430,000.
– Sale price = $500,000; selling costs (agent fees, closing) = $30,000.
– Taxable gain = 500,000 − 30,000 − 430,000 = 40,000.
Notes:
– The $30,000 depreciation reduces basis and increases taxable gain.
– Depreciation may be subject to recapture rules and taxed differently from capital gains (see sources).
Quick checklist: what typically qualifies as a capital improvement
– Adds value to the property, increases useful life, or adapts the property to a new use.
– Examples: new roof, central air installation, room addition, new plumbing or electrical system, major kitchen remodel (permanently installed).
– Keep proof: invoices, contracts, canceled checks, before-and-after photos; documentation must show work performed and cost.
What usually does NOT qualify (repairs/maintenance)
– Routine upkeep that keeps the property in ordinary operating condition.
– Examples: repainting a room, fixing a leaky faucet, replacing a broken tile (unless part of a larger qualifying renovation).
– Repairs are generally deductible as current expenses for rental/business property, not added to basis.
Recordkeeping recommendations (practical)
– Keep original receipts, contracts, permits, and proof of payment for all improvements.
– Keep before-and-after photos and contractor warranties when relevant.
– Retain records until at least three years after the tax return reporting the sale is filed; however, keep long-term records (those needed to establish basis) for as long as you own the property and at least until the statute of limitations expires on returns that report the sale.
Common pitfalls to avoid
– Treating routine repairs as capital improvements (don’t add small repairs to basis).
– Failing to adjust basis for depreciation when property was used for business or rental.
– Losing receipts or failing to document that an expense was permanently installed or improved the property.
If your situation is mixed or complex
– Conversion of a personal residence to rental, partial business use, inherited property, or prior casualty losses can change how basis and exclusions apply.
– Depreciation recapture
– Depreciation recapture — When you sell property that was used in a business or as a rental and for which you claimed depreciation deductions, a portion of the gain on sale may be taxed as ordinary income (or at a special “recapture” rate) to the extent of the depreciation previously allowed or allowable. For most real property (buildings), the relevant rule is “unrecaptured Section 1250 gain,” which can be taxed up to 25% on the part of the gain attributable to depreciation; other business property (Section 1245) has different rules. The key practical point: depreciation reduces your adjusted basis when you sell, and that reduction can increase taxable gain and trigger recapture.
How to compute adjusted basis and the taxable gain (step‑by‑step)
1. Start with original cost (what you paid, plus acquisition fees such as closing costs attributable to purchase).
2. Add capital improvements (costs that add value or extend useful life; see checklist below).
3. Subtract cumulative depreciation allowed or allowable while the property was used for business or rental.
4. Subtract any casualty or theft losses already deducted (if applicable).
Result: adjusted basis.