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How Do Capital Improvements Work?

Real estate capital improvement is an inevitable part of real estate investing. Whether you’re developing a property from the ground up or buying an existing facility, the building will need improvements over time. Capital improvements help maintain a property’s value while also keeping it competitive in the marketplace. If you’re new to investing or wanting to be more prepared for your next real estate investment, continue reading to learn what capital improvement is and how it works in real estate.

What is capital improvement?

Capital improvement as defined by the Internal Revenue Service (IRS) is a permanent improvement of a structure or property that enhances features, use, or lifetime of the building. Capital improvements do not include routine maintenance or minor repairs and upgrades like switching out a light fixture, painting the interior or exterior of the building, or removing a popcorn ceiling to have a more modern look. Instead it relates to major repairs that enhance the value or useful life of the property in the long term.

Examples of common capital improvements

Capital improvements are actually far more common than you may think and can include large improvements made to the interior or exterior of a property as well as any efforts to repair and restore a property after a disaster, such as a flood, fire, or wind damage. Generally speaking, if the improvement could be considered general maintenance or a repair, not a full blown replacement or installation, it won’t be considered a capital improvement.

How do capital improvements work?

Capital improvement is a term used to define major improvements to a property for all types of real estate, but for tax purposes it’s primarily used with personal property. Capital expenditure made to a personal residence doesn’t provide a tax deduction on an annual basis but comes into play when the residence is sold. Any qualified capital improvements can be added to the cost basis of the property and will help reduce the capital gain tax if the sale’s profits exceed the $250,000 exclusion for single owners and $500,000 exclusion for joint filers.

Any improvements made to an investment property, including a large capital improvement expense and minor updates or repairs, are tax deductible. Depending on the capital improvement project, the improvement can be depreciated with the property, which helps lower the annual cost basis for the investor or property owner. If a property is leased through a ground lease or triple net lease, where the tenant is able to make leasehold improvements, those improvements are not deductible for the landlord.

It’s also common for a city or county to have a dedicated capital improvement program that focuses on making capital improvements, such as adding a park or community center.

Capital improvement sample scenarios

Let’s say a couple who are married and filed jointly bought a property 25 years ago for $150,000, which is their original cost basis. The homeowners made roughly $185,000 in capital improvements over the 25 years, including replacing the roof twice, updating the HVAC system, two bathroom renovations, adding a pool, kitchen renovation, replacing the flooring, and installing a sprinkler system, as well as replacing all windows and exterior doors. The home was located in a market that appreciated significantly over the 25 years, and the couple is able to net $825,000 after selling the home. Since the couple has a $500,000 capital gain exclusion, they have a net capital gain before capital improvements of $175,000. Since they kept records of all of the capital improvements made over 25 years, they are able to reduce their cost basis below the $500,000 exclusion threshold, eliminating the need to pay tax on capital gains from the sale of the property.

Capital improvements on an investment property are a bit more complicated to calculate because assets may be deducted as a capital expense the year in which the improvement was made or depreciated over a period of time, which will vary depending on the asset and type of property. For example, office furniture can be depreciated over a seven-year period, while other major property improvements like a roof or kitchen remodel can be depreciated over 27.5 years.

Let’s say an investor bought a rental property for $1,250,000. The property is rented for a year, and the tenant moves out with minor improvements needed in order to re-rent. The landlord paints the home, replaces a fan, and cleans the carpet, totaling $1,900 in expenses. Since most of these are general maintenance not capital improvements, these are deducted as a property expense, not depreciated. The landlord then rents the property to a new tenant who discovers a plumbing issue that requires the landlord to replumb the property. This improvement costs $5,500 and is depreciated over a period of 27.5 years, which is $200 more than the standard depreciation on the original cost basis of the property ($125,000, or $4,545.45 per year). Any assets depreciated would be recaptured at the time of sale unless the investor utilizes a 1031 exchange.

How much should you budget for capital improvements?

As a landlord, it’s important to have designated funds that will be allocated to making capital improvements. A general rule of thumb for capital expenditures is to set aside 10% of the monthly rental income toward future capital improvements.

Homeowners who want to budget for capital improvements on their personal property should determine how much cash they can set aside for future improvements on a monthly, quarterly, or annual basis.

It’s important to note that the percentage can vary based on the property type, age of property, and condition will affect how much should be allocated each year. For example, a home that is roughly 100 years old and hasn’t had the HVAC, plumbing, or electrical replaced in over 20 years will likely need capital improvements much sooner than a five-year-old home. Also, consider the size of the property. Replacing a roof on a two-story, 2,500 square foot house will likely cost more than a 1,000 square-foot single story. It’s a good idea to gauge the cost of repairs and likely timeline for replacing, installing, or renovating the item and backtracking the cost on an annual basis.

Capital improvements in summary

Capital improvements play an important role in helping maintain and improve the life, use, and value of a property over time. If you own property, make sure you keep good records of the capital improvements made to the property, including the job, who completed the work, when it was completed, and how much it cost. While you aren’t required to submit documentation when you file your taxes, you will need this information in order to file or be able to verify the amount filed in the event of an audit.

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