Capital Improvement

Definition

A capital improvement is a permanent alteration, addition, or restoration to real property that increases its value, extends its useful life, or adapts it for new uses. To qualify (per IRS guidance), the improvement must be durable or permanent and generally last more than one year.

How capital improvements work

• They typically raise a property’s market value or expand its functionality.
• The IRS distinguishes capital improvements from ordinary repairs and maintenance: repairs that merely restore functionality or address wear and tear are not capital improvements.
• Examples of qualifying projects include adding or renovating rooms, installing built-in appliances, replacing a roof, adding siding or storm windows, installing a fixed swimming pool or driveway, and permanently affixing solar panels or a tool shed.
• Business examples include installing a new HVAC system or adding Americans with Disabilities Act (ADA) accessibility features. Public projects (e.g., creating a downtown park) are also capital improvements.

Cost basis and taxes

• Capital improvements are added to a property’s cost basis (the property’s original purchase price plus qualifying improvements). Increasing the cost basis reduces taxable capital gain when the property is sold.
• Homeowners may exclude up to $250,000 of gain ($500,000 for married filing jointly) on the sale of a primary residence if they owned and used it as their main home for at least 2 of the 5 years before the sale. Improvements can help keep gains below those exclusion thresholds.
• Repairs and ordinary maintenance are not added to the cost basis unless they are part of a larger qualifying project (for example, replacing all windows as part of a comprehensive renovation).

Example:
– Purchase price: $650,000
– Capital improvements: $50,000
– Sale price after 10 years: $975,000
– Single homeowner exclusion: $250,000
– Taxable gain without improvements: $975,000 − $650,000 − $250,000 = $75,000
– Taxable gain with improvements: $975,000 − ($650,000 + $50,000) − $250,000 = $25,000

Related considerations

• Sales tax: In some jurisdictions, qualified capital improvements performed by contractors are not subject to sales tax.
• Documentation: Keep receipts, contracts, and records proving that improvements were permanent and affixed to the property to support cost-basis adjustments at sale.
• Scope: Small repairs (painting, fixing leaks, replacing broken hardware) ordinarily do not qualify; whole-project replacements or substantial renovations are more likely to qualify.

Local rules and examples

Some jurisdictions have programs that treat capital improvements differently for regulatory or rent-control purposes. For example, New York State’s Major Capital Improvement (MCI) program allows certain landlords to pass through a portion of improvement costs as rent increases for rent-stabilized or -controlled buildings. Such programs can be controversial and vary widely by place.

Other terms

• Capital improvement fee: A one-time fee sometimes charged by a homeowners association (HOA) when a property is sold to fund future community capital projects. It commonly approximates one year of HOA dues but varies by community.
• Capital improvement plan: A multi-year plan used by municipalities or organizations to schedule, budget, and finance major nonrecurring expenses tied to buildings, land, and infrastructure.
• Certificate of capital improvement: A document used in some jurisdictions to certify that a project qualifies as a capital improvement and may be exempt from sales tax.

Bottom line

Capital improvements are permanent upgrades or restorations that add value, prolong useful life, or adapt property for new uses. They are treated differently from routine repairs for tax and accounting purposes because qualifying improvements increase a property’s cost basis and can reduce taxable capital gains at sale. Verify local rules and keep thorough records to substantiate improvements and any related tax treatments.