The IRS offers homeowners various opportunities to claim tax deductions that relate to the home; however, the cost of your home improvements is not one of them. Instead, the costs of your home improvements can save you money in the future by reducing the amount of gain that is subject to tax when you sell the home.
Tax Basis
To understand the future tax savings your home-improvement costs can provide, you need to know what your home's tax basis is. When you purchase the home, its basis will equal the purchase price plus some of the settlement costs you incur at closing. Some of these costs may include utility service installation, title fees, legal fees, title insurance, recording fees and any amount the previous owner owes in back property taxes that you agree to pay. The sum of these costs is essentially your total investment in the home, which is also the basis. When you later sell the home, your taxable gain will only include the sales price minus the tax basis. In other words, your tax basis is how you calculate your profit.
Permanent Improvements
If your home improvements add value to the home and have a useful life beyond one year, then they are considered permanent improvements. You can increase the basis of your home by the cost of these permanent improvements. For example, if you spend $25,000 to expand the size of your kitchen, your basis in the home also increases by $25,000. The effect of this increase means that when you sell the home, an additional $25,000 of the sales price will not be subject to tax since inevitably, there will be less gain on the sale.
Interest Deduction
One way you can take a deduction in the current year is to deduct the interest on certain types of financing you obtain to make the home improvements. Home-equity loans commonly provide homeowners with the necessary financing. Generally, the IRS will allow you to deduct the interest that accrues on the smaller of $100,000 in home-equity loans or the equity you have in your home (as of January 2011). For example, if your home is currently worth $350,000 and you still owe $200,000 on the original mortgage, then your equity in the home is $150,000. Therefore, if you take out a home-equity loan for $150,000 you can only deduct the interest that accrues on the first $100,000 of loan principal.
Gain Exclusion
It is possible that you may never see the tax benefit of increasing your basis for home improvements. Under most circumstances, a single taxpayer is able to exclude the first $250,000 of taxable gain that results from the sale of a main home and a married couple can exclude $500,000 (as of January 2011). As a result, the home improvement will only save you on taxes if your home appreciates more than the amount you are eligible to exclude between the time you originally purchase it and sell it. However, since the exclusion is not available for your second home, it is more likely that the basis increase to them from your home improvements will provide actual tax savings.
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