In 2022 and 2023, we’ve seen significant inflation and rising interest rates reshape many aspects of our lives, including the residential real estate market. One prominent trend is homeowners’ reluctance to sell their properties. 

This decision is based on simple economics: although selling your home now might yield a higher price than what you paid, purchasing a new one has become substantially more expensive due to soaring interest rates. Consequently, many have turned toward home improvements and renovations as a viable alternative.

However, a critical aspect often overlooked in this process is the importance of meticulously tracking these improvements. This oversight can lead to missed opportunities for both current tax deductions and long-term tax savings — benefits that hinge on detailed records and the documentation of all home improvements.

Home Sale Exclusion: A tax planning tool

Generally speaking, our tax rules dictate that if you sell an asset for more than you paid for it, you have to pay tax on the difference — the gain. And the longer you stay in your home, the bigger your gain is likely to be when you sell. 

But what’s the connection between inflation, interest rates, and home improvements? Enter IRS Section 121, the “Exclusion of Gain From Sale of Principal Residence,” more commonly known as the “Home Sale Exclusion.”

This provision is straightforward: if you’ve lived in your home for two of the last five years, you’re exempt from paying tax on the gain when you sell your house, but only up to a certain limit. If you’re single, you can ignore up to $250,000 of that gain — essentially making that part of your gain tax free. If you’re married, you can ignore up to $500,000.

But there’s one aspect to the provision that can help you even more, and it comes down to how your gains are calculated.

Calculating Gain on Sale

On one level, the gain on sale is calculated just like any capital asset:

Sales Price − Cost = Gain on Sale

But here’s an essential insight: the “cost” is not just your purchase price. It also includes all the money you spent on improvements!

In the current economic climate, many homeowners may stay in their homes for ten to twenty years. Over such a long time, even substantial improvements can seem minor. People often don’t realize how much those projects are adding up, so planning ahead and tracking your renovations is crucial.

What counts as improvements?

According to IRS Publication 523, improvements are actions that add value to your home, prolong its useful life, or adapt it to new uses. This includes additions, landscaping, roofing, insulation, built-in appliances, HVAC systems, and more. The only exceptions are minor repairs necessary for maintenance.

Example: putting it all together

Let’s say you buy your house for $400,000. If you sell it more than a decade later for $1,000,000 (there’s that inflation), you made $600,000. 

Now, if you’re married, you can ignore $500,000 of that due to the Home Sale Exclusion, but you still have to pay gains tax on the extra $100,000. Or do you?

Over the course of your years in the home, let’s say you:

• Put on a new roof for $15,000
• Bought a new HVAC system for $20,000
• Renovated the kitchen for $30,000
• Added a bathroom for $25,000
• Added a new deck for $10,000

That adds up to $100,000 in home improvements. 

If you can document those costs, you can subtract the last $100,000 in gains and sell your home without paying any gains tax on the sale.

The importance of record-keeping

While you may eventually sell your home without needing these additional costs for a full exclusion, thorough record-keeping, for instance through software like Quicken, is vital. Without proper documentation, maximizing your exclusion becomes challenging.

For more thorough documentation, remember to attach images of your receipts to their underlying transactions, and use the Home Improvement category or create a unique tag to track those costs so you can find them all when you need them.

It could easily save you thousands of dollars when it’s time to sell your home, whether or not you manage to reach a full exclusion.

Engaging a tax professional

Every homeowner’s situation is unique, and while this post provides a general overview, consulting a tax professional for personalized advice is always recommended, especially for more complex scenarios.

Conclusion

As we navigate these times of inflation and high-interest rates, understanding and leveraging tax rules related to home improvements can lead to significant savings. It’s not just about improving your home; it’s about making smarter financial decisions for your future.