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Home improvements that can lower your capital gains

A lot more is riding on home improvements than making your house nicer to live in or getting a better price when you sell. Remodeling your kitchen, adding a bathroom or even planting some shrubs can reduce possible capital gains taxes.

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True, the tax code is generous in excluding from taxes a big chunk of home-sale profit. A single seller can walk away with up to $250,000 tax-free when he sells his primary residence; a married couple won't be taxed on double that profit.

But if you net more than that, you are in for a nasty capital gains shock. And it's not just the super rich who are caught in this capital gains trap. People who have owned their homes for a long time may see substantial appreciation on the property. In some hot real estate regions, especially large cities and their suburbs, home prices have skyrocketed in only months, not years.

Robert Demmett, partner with the CPA firm of Eisner & Lubin LLP in New York City, has personally witnessed this phenomenon: "A client who lived in the Hamptons for 25 years and who sold his home made a gigantic amount of money."

No one wants to drop their home's selling price just to lessen taxes, but there are ways to work around the potential problem. The easiest method is to boost your home's value, or as it's known in tax talk, its basis. When you sell, you subtract your home's adjusted basis from its sale price to come up with your profit. If it exceeds the tax-exclusion amount, get ready to write a check to the U.S. Treasury.

Building on your basis
Uncle Sam defines basis as the amount you paid for your house. It includes settlement and closing costs and any debt. If you inherited your home, your basis is the fair market value on the day the prior owner died.

You can increase your home's basis by spending money on improvements. Just make sure the upgrades meet IRS specs. A tax-acceptable improvement must add value to your home, "considerably" prolong your home's useful life or adapt your house to new uses. Examples include installing new plumbing or wiring, adding a bathroom or paving the driveway.

"The overriding factor is doing something that improves or enhances the value of your home," says Jamshed B. Gandi, partner with the San Francisco CPA firm of Bertorelli Gandi Won & Behti. "If the items are purely for maintenance, to maintain the home, they are not included."

Simple common sense generally will help you determine what will add to your property's basis. The addition of a bathroom or an in-ground swimming pool, for example, add to basis. Installing fancy wallpaper in the master bedroom does not. Fixing leaky faucets and replacing broken fixtures won't help either -- they'll count only as repairs, which do not add value or extend the life of your home.

The IRS provides a nifty chart on page 8 of its Publication 523, Selling Your Home. The list includes:

  • Additions such as a bedroom, bathroom, deck, garage, porch or patio
  • Heating and air conditioning (for example, putting in new systems)
  • Plumbing (for example, installing a new soft water system)
  • Interior improvements, such as built-in appliances and wall-to-wall carpeting
  • Insulation additions to the attic, walls, floor, pipes or ductwork

The IRS even includes such miscellaneous items as a central vacuum, wiring upgrades or a satellite dish. So enjoy your DirecTV's 700 channels now and when you sell.

Another common and often-overlooked improvement, according to Demmett, is landscaping. Paving your driveway, erecting a fence or even putting in a retaining wall can all add value to your home, boost its basis and reduce any capital gain when selling.

Also don't forget those myriad costs associated with your house purchase. Land survey costs, attorney fees and your broker's commission all add to the value or basis of your home, notes Demmett.

Documenting your tax improvements
Experts agree that the biggest mistake that home sellers make is not documenting home improvements. Even if you have no plans to sell, hold onto every Home Depot and contractor receipt.

 
 
Next: "And if the project doesn't pass?"
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Bankrate's guide to home improvements
Tax breaks for homeowners
Making your home bird friendly
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