What is a Capital Improvement?
A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property’s overall value, prolong its useful life, or adapt it to new uses.
Individuals, businesses, and cities can make capital improvements to the property they own. Some capital improvements are given favorable tax treatment and may be exempted from sales tax in certain jurisdictions. In a business or corporate finance context, this process is similar to investments in capital expenditures (CAPEX).
Key Takeaways
- A capital improvement is a durable upgrade that increases property value, often involving a structural change or restoration.
- The IRS grants special tax treatment to qualified capital improvements, distinguishing them from ordinary repairs.
- Capital improvements can increase the cost basis of a property, reducing the tax burden when it is sold.
- In some states, capital improvements allow landlords to raise rent beyond standard limitations.
How a Capital Improvement Works
Capital improvements can significantly increase the market value and utility of a property. According to the Internal Revenue Service (IRS), a qualifying capital improvement must be durable, permanent, and last more than one year.
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 making exterior improvements like replacing the roof, siding, or windows. Adding solar panels or building a fixed swimming pool are also capital improvements.
Repair vs. Capital Improvement
The IRS distinguishes between capital improvements and repairs due to normal wear and tear. For instance, repairing a broken refrigerator or fixing leaky pipes are not considered capital improvements. However, adding solar panels or constructing a tool shed, permanently affixed to the property, would qualify.
Business-related improvements, such as installing a new HVAC system or incorporating ADA-accessible features, are also considered capital improvements.
Related Expenses
Cost Basis
The cost basis is the original cost of an asset, and the IRS has specific standards for qualifying improvements as cost-basis increases. A capital improvement must be a permanent part of the property and last at least until the property’s sale to be eligible. Routine repairs or maintenance do not qualify.
Capital Gains
Capital improvements increase the property’s cost basis, lowering potential capital gains taxes upon sale. For example, a homeowner has a capital gains exemption up to $250,000 if single and $500,000 if married and filing jointly, as of 2022. Adding the cost of improvements to the purchase price may significantly reduce taxable gains over these amounts.
Local Exemptions
Some states have unique programs for capital improvements. For example, New York State’s Major Capital Improvements (MCI) program lets landlords of rent-stabilized or controlled buildings raise rents to recoup improvement costs. However, abuse and controversy have led to calls for program reform.
Examples of Capital Improvements
Imagine someone purchasing a home for $650,000 and then spending $50,000 to renovate the kitchen and add a bathroom. Not paying sales tax due to capital improvement status, the cost basis of the home increases from $650,000 to $700,000. Selling the property for $975,000 after 10 years, with a single filer’s $250,000 capital gains exclusion, the taxable gain reduces significantly due to the increased cost basis.
What Is a Capital Improvement Fee?
A capital improvement fee is a one-time fee charged by a Homeowner’s Association when a property within the HOA is sold. This fee generally funds future improvements in the community.
What Is a Capital Improvement Plan?
A capital improvement plan outlines a community or municipality’s strategy for funding and executing major capital improvements over several years. This plan includes a list of significant, non-recurring expenditures on infrastructure along with completion timelines and financing methods.
What Is a Certificate of Capital Improvement?
A certificate of capital improvement is a document certifying a project as a capital improvement, exempting it from sales tax obligations. Property owners give this certificate to construction managers or contractors.
The Bottom Line
A capital improvement is a permanent alteration or addition to a property that increases its value or usability. Residential capital improvements enjoy favorable tax treatment, with improvement costs deductible from capital gains upon sale. Understanding and distinguishing between capital improvements and routine repairs is essential for optimizing property investment.
Related Terms: capital expenditures, extraordinary repairs, cost basis, capital gains, capital improvement fee, certificate of capital improvement.
References
- Internal Revenue Service. “Publication 523”.
- Internal Revenue Service. “Topic No. 701 Selling Your Home”.
- Curbed. “Legislators Seek to Outlaw Rent Hikes Tied to Major Apartment Improvements”.
- The Kolb Team. “What Is the Capital improvement Fee?”
- University of Wisconsin-Stevens Point. “Planning Implementation Tools–Capital Improvement Plan”.
- Grist Project Management. “Certificate of Capital Improvement”.
