Making Home Improvements? Why It's Important to Keep Good Records

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  • Selling a home at a profit can trigger a tax liability.
  • You can use the cost of home improvements to lower the sum you owe the IRS.

That information could come in handy when you go to sell.

There are plenty of reasons you might choose to renovate your home. For one thing, doing so could improve your quality of life.

Say you have an unfinished basement, but your upstairs is loaded with your kids' toys. If you spend the money to finish up that space, voila -- instant playroom.

Renovations can also add value to your home, making it easier to command a higher price when the time comes to sell it. But if you're going to make home improvements, it's important to keep solid records of the amount you spend on them. Here's why.

It's all about minimizing your capital gains

When you sell a stock in a brokerage account at a price that's higher than what you initially paid for it, you're subject to capital gains taxes. Similarly, when you sell a home at a profit, capital gains taxes apply as well.

That said, as a homeowner, you're entitled to a pretty decent exemption on the capital gains front. If you're single, you can exclude up to $250,000 in gains from a home sale, and if you're married, you can exclude $500,000. All of this assumes you owned and lived in your home for at least two years within the five-year period leading up to the sale of that property.

So, here's how capital gains on a home sale might work. Let's say you purchased your home for $300,000 and are selling it many years later for $900,000 jointly with your spouse. Normally, you'd be looking at $600,000 in capital gains. But because you can exclude $500,000, your tax liability is whittled down to $100,000 in capital gains. (To be clear, you wouldn't owe the IRS $100,000 in that situation -- you would simply pay taxes on that $100,000.)

Now, here's where home improvements come into play. When calculating capital gains, you can include certain expenses in the cost of your home. These include real estate agent fees you incur in the course of selling your home, and they also include home improvements.

So, let's say you bought your home for $300,000 but also spent $30,000 to finish your basement. Let's also say you paid a real estate agent $45,000, or 5% of your home's sale price. All told, that's another $75,000 you can add to the cost of your home, bringing it up to $375,000, and shrinking your capital gain down to $25,000.

But to count home improvements in that situation, you need records of what you spent. So as you renovate through the years, make sure to keep all of your receipts on hand. A good bet is to scan them and store them electronically so they don't degrade over time.

What about home repairs?

While you're allowed to include home improvements in your home's cost basis when you go to sell it, home repairs are a different story -- namely, because they can't help you offset your capital gains liability. So if you spend $40,000 through the years on various fixes, you unfortunately cannot add that $40,000 to the cost of your home in a sale.

But remember, any time you add a feature of value to your home, like a deck, fence, or swimming pool, it could help you pay less on your home sale down the line. So be sure to track that spending as you go.

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