The Money Pit: What It Means For Your Taxes

By HMA Team on April 27, 2021

Authored by Maria Kernahan

There’s a scene in the classic Tom Hank’s movie “The Money Pit” where a young couple’s renovation literally crumbles beneath them. Tom Hanks is left hanging after a grand staircase has fallen apart below him.

Anyone who’s braved a home renovation can relate.

Renovating your property is a smart financial choice. Not only do you get to enjoy your updated, expanded, or modernized home, the IRS lets you deduct the cost of any capital improvements from your property’s cost basis.

A capital improvement, in the eyes of the IRS, is work that adds value to your property. Did you fix a hole in your roof? That’s a repair, not a capital improvement. But if you put in new hardwood floors or remodeled a bathroom, that is value-added and considered a capital improvement.

The government wants to encourage home ownership, so there are many tax advantages to owning your home, including deducting (some) property taxes from your annual income tax burden.

But the capital gains rule on real estate is particularly sweet: Individuals can exclude up to $250,000 of profit on the sale of their real estate (and married couples filing jointly can exclude up to $500,000) given that you have owned the home and lived in it for the past two years.

Where do capital improvements come in? The cost of any project that improves the value of your home can be added to the cost basis of your property.

For example, let’s say you purchased a home in 2011 for $900,000 and over the past ten years have done a number of capital improvements on the home, bringing the market value substantially. The kitchen and baths have been renovated, new floors installed, new landscaping and a beautiful new deck with pizza oven and fireplace installed. The total of your improvements equaled $350,000. Now, for purposes of your potential capital gains, the cost basis on your property is $1,250,000.

Good news! That killer deck got a pretty price for your home. You were able to sell it for $1,750,000! If you are filing jointly with a spouse, you pay no capital gains on your sale.

                             $900,000             Initial Purchase

                                        $350,000             Capital Improvements

                                                      $1,250,000          Cost Basis for Capital Gains

                             $1,750,000          Sale Price

                    –    $1,250,000          Cost Basis

                          –    $ 500,000          IRS Exclusion

                             ____________________

                    $0       Capital Gains Tax Due

Upgrading your property is usually a great idea. Make sure you connect with your real estate professional to make sure that the improvements you are planning will bring you top resale dollar. Some projects, like kitchen, baths and yes, decks, get a great return on the investment. But you need to be smart about finishes and selections – hand-painted Cubs tiles may create a bath of your dreams, but if your next buyer is a Sox fan, you may have lost a sale.

Happy home renovation – and don’t forget to save your receipts!

Maria Kernahan is a real estate professional with The Kernahan Group, a division of @Properties. Maria has sold real estate in Chicago and on the North Shore for over 20 years. Along with her husband Will, they work with clients on buying and selling properties, and advise them on the best choices for a home renovation.