A Seller’s Guide to Home Cost Basis: How to Turn Home Improvements into Tax Savings

After a home renovation, all you want to do is sit back and enjoy your freshly updated space. Fast forward 10 years, it might be easy to forget about that kitchen remodel or all those other upgrades you made. What you might not realize is that those renovations not only boost your home’s value but also increase its cost basis. This can have a big impact on your tax bill when you sell. 

Ready to make your home updates work for you? Let’s dive in.

The Basics of Cost Basis

Before getting into the nitty gritty, there are two important questions you need to know the answer to: what does home “cost basis” mean and why is it so important? 

Cost basis (also known as basis) typically refers to the original price you paid for the home. However, it also includes closing costs paid by you, legal fees, inspection fees, title insurance, real estate agent commission, etc. It can be adjusted over time to take into account capital home improvements made, which is then referred to as adjusted cost basis.

This adjusted cost basis can directly affect the amount of taxes you’ll owe on any profit (or gain) from selling your home. The IRS uses your adjusted cost basis to determine how much profit you’ve made on the sale of your home. The higher your adjusted cost basis, the lower your profit, which can significantly reduce the taxes you owe. Please note a loss on the sale of your home is only allowed if it was used for business or investment purposes, such as a rental property. 

The Impact Cost Basis has on Your Tax Savings

Now, this is the part where all those calculations really matter. Before giving you an example, it’s important to note that the IRS will allow you to exclude up to $250,000 of the gain (or $500,000 for most joint filers) on your primary residence if you meet certain eligibility criteria.* With the huge increases in home prices we’ve seen since 2020 in areas where our clients live (Richmond and Arlington, VA, Boulder, CO, beach communities in NC) this issue is coming up for more and more of our clients. 

Example: If you bought your primary home for $400,000 and sold it for $700,000 then your gain is $300,000. You may be able to exclude $250,000, therefore only paying taxes on the remaining $50,000 of gain ($300,000 gain – $250,000 exclusion). 

Let’s assume you are in the 15% Federal capital gain tax bracket and filing as single, even after taking the home exclusion of $250,000 you will still owe approximately $7,500 in federal taxes plus any state capital gains taxes. 

$50,000 gain above the $250,000 exclusion x 15% Federal Capital gains rate = $7,500 in Federal taxes owed

However, assume you remodeled your kitchen a few years ago and it cost $50,000. That increases the adjusted cost basis of your home from $400,000 to $450,000, meaning your gain now would only be $250,000 ($700,000 sale – $450,000 adjusted cost basis). 

Due to the home exclusion, the total tax owed would be $0.  

Therefore, the higher your adjusted cost basis, the lower your taxes. If you made home renovations and don’t calculate the correct basis, you are leaving money on the table!

* IRS Publication 523 has the complete eligibility requirements. 

How do you calculate your cost basis or adjusted cost basis? 

First you would start off with the cost basis which as referred to above is the original price paid plus additional costs. Then you want to include the capital home improvements made throughout the time you owned the property. What are these capital home improvements we speak of? Capital home improvements are improvements made to the property that will add value and/or prolong its life. 

Below are a few examples of capital home improvements and deduction, please refer to Publication 523 from the IRS for more information. 

The adjusted cost basis is calculated by taking the original purchase price of the home, adding the cost of capital home improvements, and subtracting certain deductions for rental property such as depreciation taken. 

Adjusted Home Cost Basis Calculation

To calculate the adjusted cost basis of a home:

1. Start with the original purchase price
2. Then add factors that increase the property’s value 
3. Then subtract deductions

Example: If you bought your rental property for $300,000, $40,000 of depreciation was taken over the years, and you spent $20,000 renovating a bathroom, your adjusted cost basis would be $280,000. 

Calculation:

1. Start with the purchase price: $300,000
2. Add the renovation cost: $20,000
3. Subtract the depreciation: $40,000 

Note: It is important to keep the receipts for all of your home improvements and organize them somewhere you won’t forget. When it’s time to sell your home, you’ll be thankful you kept yourself organized. That way, you can easily reference your receipts when calculating your adjusted cost basis. 

Spark Clients: These details/receipts can be saved in your Box folder for safe keeping.

Own a rental property? Want to minimize taxes to your heirs at your passing? We’ve got you covered:

What Happens to my Joint Rental Property when I Die? Depreciation and the Step-Up in Basis

What’s Not a Capital Improvement?

The IRS separates home improvements from items like home maintenance or repairs. Maintenance or repairs do not increase your adjusted basis. 

Example of non-capital improvements (do not increase basis):

• Repairing your roof 
• Paying for lawn service 
• Painting a room

All of this to say, your home’s cost basis matters! When selling your home, correctly calculating your adjusted cost basis directly correlates to how much money ends up in your pocket at the end of the day. That’s why we emphasize the importance of diligently tracking those home improvements. So when the time comes, you won’t have to go rummaging for all those receipts, invoices, or even simply forgetting about one of your home upgrades!

This is educational in nature. Please consult with your CPA for tax guidance and your financial advisor before making any changes.