Now we are in the middle of 2024 and are squarely in home-improvement season. In fact, the warm-weather seasons are the most popular time of year to do home improvements because of its perfect combination of favorable weather, renewed energy, and inevitable summer gatherings and gardening to follow. Plus, it’s prime real estate selling season.
With taxes, hopefully, still fresh on your mind, you might even be thinking that your upcoming home improvement project could benefit you on your next tax return. Many of my clients have expressed confusion about whether improving their homes will help with their taxes.
To that question, my answer is: It depends.
If the home is a rental property, one that provides you with passive income, you might be able to deduct that upgrade or repair. But if the home is your residence, deductions are only allowed in very specific cases. Let’s discuss the tax benefits of home improvements in detail.
Rental Properties and Businesses
In short, if the property you plan to improve is a rental property that provides you with an income and is not your residence, any improvements you make would either be fully deductible in the year they were completed, or they will be put on a depreciation schedule and depreciated over a fixed period, as determined by the IRS. The deductibility of the improvements will depend on the dollar amount spent as well as the type of work that was done. For example, replacement of your HVAC system would usually be depreciated over 27.5 years for a residential rental. However, repairing and replacing certain components of the HVAC could possibly be expensed as repairs in the current year.
Simply put, the depreciation deduction is figured out as follows. Let’s say you buy a property for $100,000 (in some imaginary country where this might be likely), with the intent to improve it and then rent it out. According to the IRS General Depreciation System (GDS), the length of the depreciation period is determined by the type, or class, of property. A residential rental property is depreciated over 27.5 years. So you would receive a depreciation deduction every year for 27.5 years at a rate of just over $3,600 per year. Additionally, if you repair its roof, replace the flooring, buy new appliances, or make other substantial improvements, those improvements would be on their own depreciation deduction schedule, and those deductions would be in addition to the $3,600 depreciation expense you are already taking on the building.
Note that depreciation is an automatic deduction. If you don’t take the deduction in full for the year it occurred, the IRS will assume you are depreciating your building and improvements annually, as prescribed. You don’t have the option to not take depreciation one year and catch up later. If you don’t claim the depreciation each year on your return, you lose that year; the clock began to tick in the year you made the improvement, whether you take advantage of the depreciation or not, so if you don’t use it one year, you lose it. There is a way to correct overlooked depreciation expenses by filing Form 3115 – Application for Change in Accounting Method. It’s as complicated as it sounds, and we recommend taking the depreciation deduction when it’s available.
Improvements to Your Primary Residence
As for your home, the rules are quite different. Simply put, home improvements don’t get an immediate tax break, and you may never see a tax break. So, for example, if you purchase your home for $500,000, then spend $50,000 on home improvements, you now have a tax basis, or the asset’s monetary value for tax purposes, of $550,000. Could that help you in the future? Perhaps. If you sell your house for $700K, your realized gain would be:
$700K (selling price) – $550K (tax basis) – (commissions and selling costs are disregarded for this example) = $150K of gain realized
But “realized” doesn’t necessarily mean “taxable” in the world of tax accounting. If you’re a single homeowner and have lived in your home for at least two years, the IRS’s personal residence sale exemption rule says you can deduct up to $250,000 against your realized gain ($500K for married couples). In other words, that $250K deduction erases any tax benefit from the capital improvement you were planning to receive.
In general, the only situations in which improvements made on your primary residence have tax benefits are the following:
• Installation of solar energy system: 30% tax credit of the total cost in the year in which it was installed
• Installation of new energy-efficient appliances (up to a maximum credit of $1,200 but the devil is in the details — a new, energy-efficient door would only allow $250 credit, a window $600, etc.)
• Medically necessary renovations: wheelchair ramps, lifts, etc.
• Adding or improving office space for a home-based business
In the case of a business operating out of your home, improvements, such as new office furniture or a new computer, would follow the depreciation schedule.
A Few Words of Caution
While I’m on the topic of home improvement, I would be remiss if I didn’t offer a few words of advice about home improvement funds and recordkeeping:
• Avoid home equity loans if possible. Since home values are high, a lot of homeowners consider refinancing and using the equity in their homes to pay off other debts or purchase new vehicles. Aside from the fact that it’s not tax deductible, it is just bad financial practice. I recommend paying down your mortgage as much as possible. In the past, I’ve seen too many clients encounter trouble with home equity loans or lines of credit when home values declined and adjustable interest rates on equity loans had gone up.
• Keep careful records. When it comes to home improvement, you just never know what the future holds. You might be audited, or you might need to access receipts from a home improvement 10 years from now. Unlike many tax records, which only need to be kept for seven years, keep your home improvement receipts as long as you have the home, and for seven years after you have sold it. Online or cloud storage is great, but there will always be fees and login information associated with those, meaning there’s inherent risk that you or your loved ones could lose access. Be sure someone in the household knows where to find those materials. Accountants are often a reliable second storage option for your records.
As always, we’re ready to talk to you about any home improvements you’ve done recently or might be considering and how they may affect your tax return. Contact us today!In the meantime, enjoy your summer!