Tax Guidelines on What Qualifies as ‘Improvement’
QUESTION: What improvements is a home seller allowed to add to his cost basis? I know that general maintenance does not count and that additions, such as fences, decks and added rooms, do count. I am uncertain, however, about replacements. In our home of 25 years, every major appliance has been replaced at least once, including the furnace and water heater. Can we add the cost of these replacements to our basis?
ANSWER: This is a very important subject that is often overlooked by homeowners. Over the last quarter-century, real estate values have skyrocketed, and when the homeowner sells the property, every dollar that can be added to cost basis is a potential 33 cent savings on federal income tax.
The tax court cases that have discussed the issues of capital improvements are usually raised in the context of whether the real estate investor can deduct certain expenses in the year they are paid, or whether those expenses have to be added to the basis.
Obviously, from the point of view of the investor, if expenses can be deducted legitimately in the year they are paid, this is more desirable than merely tacking these expenses to the cost basis for a future savings down the road.
The distinction, while significant today, was more important prior to the 1986 Tax Reform Act. Investors wanted to take advantage of a tax savings in the year the expenses were paid, rather than wait for a future date.
For the homeowner, the situation is the reverse. Ordinary expenses for repairs are not deductible under any circumstances when the repairs are made to your principal residence. Thus, to the extent possible, the homeowner wants to treat these expenses as capital improvements, thereby permitting those expenses to be added to the cost basis of the property.
Many fine lines can be drawn. For example, if the toilet is leaking, and you merely repair that toilet, I think there is no question but that this is a repair--and not a capital improvement. But if you replace that same toilet with a new one, a good argument can be made that this was a capital improvement--and not merely a repair.
One of the most concise definitions is found in an early tax appeal case where it was stated:
“To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired.
“Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements or additions that prolong the life of the property, increase its value, or make it adaptable to a different use.”
Oversimplified, the distinction between a repair and a capital expenditure rests on whether the work or construction prolongs the life of--or adds value to--the property.
As in many tax questions, the matter will be resolved not by a legal interpretation, but on the facts of each case.
Some tax court cases have applied the “one-year” rule of thumb. Under this theory, an expenditure would be capitalized “if it brings about the acquisition of an asset having a period of useful life in excess of one year or if it secures a like advantage to the taxpayer, which has a life of more than one year.”
Thus, in your example, since you replaced the furnace and water heater, and they clearly prolong the life of your house for more than one year, I certainly feel that you are justified in calling these items improvements and adding those costs to your basis.
It is interesting to note that the following items have been determined by either the IRS or by a court to be a capital expenditure--rather than a repair: cost of replacing, rearranging and new electrical wiring; basement repair and waterproofing costs; burglar alarm installation charges; cost of new flooring; cost of replacement of drainage pipes; installation of sea walls; cost of replacement and renovation of roof, and costs of window plate-glass installation and replacement.
Thus, as you can see, the answer depends on the particular facts. My own suggestion is that if you are satisfied that the work you have done to your property prolongs the life of your property or adds value to the property, I would consider those costs to be capital improvements, thereby adding them to the cost basis of your property.
Keep in mind that if you are audited, the burden will be on you to demonstrate that these are, in fact, improvements and not merely repairs.
You should also keep all records and bills relating to these improvements. Even if you can justify that the replacement of your boiler was clearly a capital improvement, if you do not have the bill for this new boiler when you are audited, you will have great difficulty having this addition approved.
Kass is a Washington lawyer and newspaper columnist specializing in real estate and tax matters. While questions cannot be answered individually, those of general interest will be addressed in this column. Questions and comments may be sent to Kass at 1050 17th St. N.W., Suite 1100, Washington, D.C. 20036.