Home improvement tax deductions are a common subject of discussion, especially around tax time. Property owners are always looking for ways to reduce their tax burden and end up with extra money in their pockets. The problem is that taxes can be complicated. When you add the IRS regulations regarding home improvements and tax deductions, taxes can feel overwhelming.
A tax deduction is an expense that taxpayers can claim on a return to lower the tax an individual must pay. The terminology itself can seem confusing. Deductions, Tax credits, capital improvements, home repairs; how is the general tax filer supposed to figure out the rules?
Nobody wants to make a mistake on their tax return. Not only can it delay a refund, but it can put your name on the dreaded IRS audit list. Facing an audit because of an honest mistake certainly isn’t most people’s idea of a good time.
In this article, we will help unravel the details of home improvements that can be used as a tax deduction and offer guidance for property owners to help them get the most bang for their tax buck.
The Relationship Between Tax Deduction and Home Improvements
Home improvement tax deductions are a great way for property owners to get a bit of money back from Uncle Sam. But as with anything, the IRS has strict rules about which home improvements qualify for tax deductions. Certain home improvements can qualify as a deduction on a tax return, and others cannot.
Not only that, but different rules apply to homeowners or those who live in their property as their primary residence and those who make improvements or repairs to investment, rental, or business properties.
What Are Tax Deductions?
The IRS defines a tax deduction as an expense that can be subtracted from a taxpayer’s gross income to reduce the amount of income that is subject to taxation. It’s important to note that taxpayers must itemize their tax returns instead of using the standard deduction if they wish to deduct home improvement expenses. If the amount of savings totaled by itemizing is less than the standard deduction, then it makes more sense to file a simple return and claim the standard deduction amount.
For example, let’s say your taxable income is $50,000. If you claim a tax deduction worth $5,000, it will lower your taxable income to $45,000. If that $5,000 deduction is the only one available, it’s likely that claiming the standard deduction will save you more money in the end.
However, many expenses qualify as a deduction, so it could be beneficial to check out the list and see if any other costs incurred during the year might be included on an itemized return to maximize savings.
What Are Tax Credits?
You may hear the term “tax credit” used in certain situations, such as energy tax credits offered for energy-generating improvements like solar panels. A tax credit is different from a deduction and is an amount of money given to a taxpayer by the IRS that reduces their tax bill.
Rather than lowering the amount of taxable income, a tax credit is subtracted from the final tax bill. A tax credit is available regardless of whether you itemize or take the standard deduction.
Home Repairs Vs Home Improvements: Studying the Tax Differences
There are differences between how the IRS treats property used as a taxpayer’s primary residence and property used for business purposes, investment, or rental profit. And further, there is a difference between what the IRS considers a repair and an improvement.
The first step in understanding how to get the biggest advantage at tax time is to understand what the IRS considers a repair versus an improvement, and how they are treated differently.
What is a Repair?
Think of it like this: when you repair something, you are putting it back in working order. That doesn’t mean it will last longer, work better, or be worth more money than it originally was. It only means you have taken action to maintain its original purpose, quality, and usefulness.
Repairs are tax-deductible expenses that can be claimed the same year they were performed, assuming the property is not your residence. The deduction would be subtracted directly from any rental income received during the same period and can even carry over to subsequent years in certain situations.
It’s also important to note that repairs or improvements to rental properties may fall under “safe harbor” rules. This means that under certain circumstances, a capital improvement that would otherwise depreciate over several years can instead be deducted in its entirety during a single year.
What is a Capital Improvement?
According to the IRS, improvements are changes, additions, or upgrades made to a property that either adds to an asset’s purpose or extends its “useful” life. You may hear them referred to as “capital improvements.” They are typically larger, expensive projects, and the IRS treats them differently than simple deductible expenses
because it assumes they add significant value to a property.
If a capital improvement is depreciated, the cost is divided over the number of years determined by how long you expect that asset to remain useful. Then a percentage of the cost is deductible each year until the asset’s usefulness has expired.
Some examples of capital improvements are:
- Building an addition, like a new room or garage
- Renovating an entire room, like a kitchen or bathroom
- Building a swimming pool or deck
- Adding landscaping elements, driveways, or walkways
- Installing a fireplace
- Adding insulation, ducts, or pipes to flooring or walls
- Replacing a roof, siding, or shingles
- Replacing all the windows or doors
- Upgrading to central air or replacing a heating system
- Adding a security system
- Replacing home systems, such as plumbing, electrical, septic, filtration
- Replacing appliances, water heaters, or water softeners
To determine if something is a capital improvement, ask yourself this: did you add something tangible to a property? Or did you add something that adds immense value to the property? If the answer to either of these questions is yes, then the IRS considers it a capital improvement.
Understanding the Differences Between Home Betterment, Home Restoration, and Home Adaptation
Every homeowner understands the importance of budgeting for regular home repairs. Even a small repair or appliance failure can mean big bucks out of the monthly budget.
Homeowners should familiarize themselves with how the IRS qualifies tax deductions, repairs, and improvements. After all, owning a home is likely one of the most expensive undertakings most people will experience. Why not look for every chance to get a few bucks back?
The IRS loves to complicate things for taxpayers with long lists of rules and regulations. Another way taxpayers get tripped up is by trying to navigate terminology. Three terms homeowners should learn and understand are betterment, adaptation, and restoration. Understanding the definition of these three terms as the IRS sees them will help homeowners maximize their home improvement tax deductions.
The IRS defines a betterment as an expense that results in improvements to a property. Betterments can be repairs to pre-existing conditions or defects, expansion or enlargement of a property, or improving the strength, quality, or capacity of a property.
· Home Adaption
When you alter or adapt your property for a use other than its original intended purpose, it’s considered an adaptation. This could mean converting part of a property for business use or adding an extra room as a home office.
· Home Restoration
Restoration of a property is pretty much just what it sounds like – restoring something to what it once was. Restoration is usually necessary after a natural disaster, like a flood, fire, or major weather event. Think water and mold removal, cleaning up soot and ash, and structural repairs.
Restoration can even include rebuilding a property from the ground up after a catastrophic casualty loss. These types of repairs most commonly involve the cooperation of an insurance company.
What IRS Considers a Unit of Property (UOP): The Inclusions and Strategies
Another way the IRS complicates things for taxpayers is by changing the rules halfway through the game, or in the case of tax filings, as often as every year. A great example of this is the way the IRS added definitions for what they consider to be a “unit of property” back in 2013 as part of regulations referred to as “tangible property and repair regulations.”
A few factors determine how the IRS handles home improvement tax deductions; whether the expense was an improvement, betterment, adaptation, or restoration, and the unit of property in question. So, what exactly is a unit of property, and why does it matter?
Defining a Unit of Property
The IRS defines a unit of property as all the functionally interdependent components of a structure. For example, a building has structural components that are connected and reliant on each other. The same applies to a vehicle. All the parts are necessary for the vehicle to function properly.
The new regulations consider a building to be a single unit of property. The method used to determine whether an expense is a capital improvement or not takes into account the specific part or system of the building affected. The IRS divides a typical building into the structural components themselves and nine separate “building systems,” including:
- Fire protection and alarm systems
- Security systems
- Gas distribution system
- Any other defined systems
Why It Matters
The point of the expanded definitions was to help taxpayers better understand which expenses are considered capital expenditures and which are not. Understanding and applying these rules correctly can also help property owners avoid capitalizing expenses which could otherwise be considered regular repairs.
As the IRS sees it, any expense related to a building’s structure or any of the above-listed systems is likely to be considered a capital improvement. However, other portions of a property, like non-buildings, must be accounted for as well.
In general, the larger the expenditure, the more likely it is to be seen as a capital improvement. Understanding how the IRS categorizes improvements can help taxpayers check the right boxes on their tax returns.
What Home Improvements are Tax Deductible?
As mentioned earlier, a few home improvement tax deductions fall under special rules. Regular repairs are not tax deductible. Large, expensive improvements are considered capital gains and are treated differently. However, if your home improvement project falls into one of the following categories, you may be eligible for a tax benefit. You may be allowed to deduct the cost from your taxable income in the same year it occurred or reap the benefit when you sell the property.
Tax Benefits for Homeowners
For the most part, the IRS considers improvements or repairs to property used as a taxpayer’s primary residence to be personal expenses and, therefore, non-deductible. However, that doesn’t mean that home improvements can’t save you money further down the road.
Homeowners can add the total cost of a home improvement project to the “tax basis” of their home. A higher tax basis will decrease the amount of profit considered taxable after a sale. Homeowners must keep careful and detailed records related to home improvements if they intend to add the expense to their home’s tax basis.
Energy-Efficient Home Improvements
Energy-efficient has become somewhat of a buzzword over recent years. A push to limit greenhouse gases and carbon footprints is somewhat of a global effort, and one of the ways the government incentivizes taxpayers to play their part is by offering tax deductions or credits on certain qualifying home improvements.
Some examples of energy-efficient upgrades are:
- Energy-efficient doors, windows, and skylights
- Air-source heat pumps, central air, hot water heaters, and circulating fans
- Geothermal heat pumps
- Wind turbines
- Solar energy systems
- Fuel cells
- Biomass fuel stoves
Home Improvements Related to Medical Care
Another way to earn a tax deduction is by including expenses considered medically required for you or a family member living with you. Numerous additions fall into this category, including:
- Widening doorways
- Building entrance or exit ramps
- Adding railings
- Installing stairlifts
- Adding support bars in the bathroom
- Modifying fire alarms or smoke detectors
- Lowering or modifying cabinets
Home Office Improvements
With the number of people working remotely or running businesses from home increasing, this tax deduction is becoming more popular. There are numerous tax deductions available if you use a portion of your home as a home office, including improvements to the space.
There are stipulations to this deduction which include ensuring that the space used as your home office is only used for that purpose, and your home is the principal place of your business. Another consideration is that you don’t qualify for the deduction if you’re an employee who earns a W2 and works from home.
Because your home office shares certain components with your residence, even a percentage of certain repairs or improvements that include the entire building may be tax deductible. For example, if your furnace or AC system fails in one part of the house, it will likely affect your office as well. Therefore, a matching percentage of the space occupied by your office can be applied to the repair cost and deducted accordingly.
Maximizing Your Savings for Home Improvement and Repairs
Navigating tax returns can be tricky and requires knowledge of the rules, regulations, and policies that apply to your situation. Understanding the information provided in this article is a great head start on managing home improvement tax deductions. However, property owners need to take every opportunity to maximize savings and get the most out of every dollar spent.
Here are a few suggestions on how to ensure your tax return is crisp, polished, and optimized for your financial benefit:
Plan ahead – Before undertaking any major repair or improvement project, make sure you’re looking ahead and considering how the expense will affect your tax liability.
Shop around – Saving money through tax deductions is great but finding the best deal for a project before it starts is even better. Look for sales and savings opportunities, get quotes from contractors whenever possible, and compare material costs before getting started. However, be sure to remember that cheaper doesn’t always equal better.
Partner with a realty professional – Realty companies are a great source of information regarding resale values on a property. Ask around for information about what kinds of home improvements will have the greatest effect on your tax bill when it’s time to sell.
Always ask for tax advice – Filing a simple 1040EZ and claiming the standard deduction is one thing, and most people can probably navigate the process successfully. Property owners, on the other hand, have it much harder. Partnering with a tax professional to help put together your return and keep you updated on changing laws and regulations is the best way to avoid costly mistakes.
Build a nest egg – Just like you set aside a portion of your income for retirement, every property owner should have a separate fund for home repairs and improvements. Setting up a designated account for these expenses will help you budget and save more effectively. Experts recommend setting aside between 1% to 4% of your home’s value for this purpose annually.
Tax deductions are a great way to recoup some of the money spent on property repairs or improvements. But unfortunately, not all repairs are treated equally. That’s why understanding the rules and regulations regarding home improvement tax deductions is so valuable.
Property owners often face an uphill battle in maintaining their home’s equity; building structures inevitably wear out, systems break down, and appliances need to be replaced. It can feel never-ending and overwhelming at times.
In addition, our homes are an extension of ourselves. They represent how we want the world to be. They are the place where we spend the most time, so wanting to make them as inviting as possible is a normal desire.
Home improvement projects can be extremely stressful and incredibly gratifying at the same time. But there’s no denying that owning a property, whether personal, business, investment, or otherwise, is expensive. So make the most of your time and money, and next tax season, the IRS will be working for you.