Making Home Improvements Less Taxing

I recently bought a house, and have already made quite a few improvements. Am I eligible for any tax breaks?

Home improvement is the new American pastime. Sit a couple down with a bottle of wine, and inevitably the conversation turns to the fascinating nuances of granite vs. marble countertops, brushed nickel vs. chrome fixtures and eggshell vs. matte paint.

Conventional wisdom holds that there's no such thing as a foolish home improvement, since it will likely increase the value of the home and might even entitle the homeowner to a tax break or two. Unfortunately, that's not always the case. Here's an overview of the improvements that earn Uncle Sam's stamp of approval. (For more on how a home improvement can increase your home's sale price, click here.)

The biggest tax advantage offered by some home improvements is that they can increase a home's cost basis when it's sold. This is essentially the portion of your home's sale price that's not subject to a capital gains tax. Your cost basis is the price that you paid for your home, plus various other things, such as certain home improvements, closing costs and legal fees. Let's say you bought a house for $150,000 and then, a year later decided to move. The IRS allows you to add the amount you spent on closing costs — say, $5,000 — onto your cost basis. When you report the profit you made on that house to the government, you can essentially tell the IRS you paid $155,000, which will decrease your taxable profit by $5,000.

Certain home improvements can also increase your cost basis. Which ones? Good question. There's no definitive list. All the IRS tells us is that an improvement must add value to the residence, prolong its useful life or adapt the house for new uses. Experts agree that replacing a roof, installing central air conditioning or renovating a kitchen will qualify. Even installing carpeting or refinishing a wood floor counts, since they are permanent improvements that you can't take with you when you move onto a new property, says Mary Gutierrez, a tax research specialist with H&R Block.

Unfortunately, the IRS categorizes some things that you might consider improvements as repairs — which offer no tax break. Repainting the house, for example, doesn't cut it. Nor do fixing leaks or plastering walls, unless those activities are part of a larger renovation, says Lee Steinmetz, a CPA with New York-based financial and tax planning firm Joel Isaacson & Co.

If you plan to add the cost of improvements to your cost basis, be sure to keep good records. If you're audited, the IRS will want to see every last receipt, whether it's from Home Depot or your contractor. (The cost of labor counts toward your cost basis, as well.) H&R Block's Gutierrez recommends all homeowners start a file for their expenses as soon as they move in so they don't have to scramble trying to find documents when they go to sell their home.

Of course, the discussion of tax basis is moot if you don't generate a taxable sale when you sell your home. As most homeowners are fully aware, couples who have lived in their house for at least two of the last five years get a $500,000 capital gain tax exclusion; for singles it's $250,000. So if, say, you're married and the value of your home increased by a whopping $350,000 — thanks in part to a $75,000 kitchen renovation — well, your profit is already tax-free anyway.

There is one other potential tax break that we should mention, although it most likely won't apply to many people. New for tax-year 2004, taxpayers can elect to deduct their sales tax instead of their state and local income taxes as an itemized deduction on their Schedule A (Form 1040). This has obvious appeal to those who live in states with no or low income tax, such as Florida or Nevada. So if you buy, say, kitchen cabinets, you can deduct the sales tax from your federal taxes, says Martin Nissenbaum, national director of personal income tax planning for Ernst & Young. Keep in mind that if you go this route, you won't be able to add the sales tax to your cost basis later on. For more on this, read our article and IRS Publication 600.