Capital Improvement Definition

A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property's overall value, prolongs its useful life, or adapt it to new uses. This type of improvement, according to the Internal Revenue Service (IRS), must endure for more than one year upon its completion. Although the scale of a capital improvement can vary, both individual homeowners and large-scale property owners make capital improvements.

IRS Publication 523 outlines the definition of a capital improvement. Examples of capital improvements include adding a bedroom, bathroom or deck; adding new built-in appliances, wall-to-wall carpeting or flooring; or improvements to a home's exterior, such as replacing the roof, siding or storm windows.

For the improvement to qualify as a cost-basis increase (see below), it must be in place at the time a property is sold. A capital improvement must also become part of the property or must be affixed so permanently to the property so that the removal of it would cause significant damage to the property itself.

For example, if a person buys a new hot water heater and a tool shed for his property, both of which are attached to the house, they would be considered capital improvements to the home. Similarly, the creation of a new public park in a downtown area would also be considered a capital improvement for a city. In these scenarios, the new additions would make the respective properties more valuable, would be considered permanent additions, and their removal would cause material harm to the home and the city's property.

The IRS makes a distinction between capital improvements and repairs, which cannot be included in a property's cost basis. Repairs done as part of a larger project, such as replacing all of a home's windows, do qualify as capital improvements. Repairs that are necessary to keep a home in good condition, however, are not included if they do not add value. Examples of such non-qualifying repairs, according to the IRS, include painting walls, fixing leaks, or replacing broken hardware.

In addition to improving the home, a capital improvement (per the IRS) increases the cost basis of a home. That is, expenses incurred upon making the improvements are added to the amount the owner paid to buy or build the property (his cost, in other words). Augmenting the cost basis, in turn, reduces the size of the taxable capital gain—his profit, that is—when selling the property.

Capital gains don't kick in right away with real estate. As of 2019, homeowners are entitled to a capital gains exemption on any profit from the sale of a primary residence up to $250,000 if single and $500,000 if married and filing jointly, provided that they have lived in that residence for at least two of the last five years before the sale. But if the gain is significantly more than these sums—and it happens more often than you'd think, if the owners acquired the property many decades ago and/or local real estate values had dramatically increased—capital improvements' effect on the cost basis can be significant.

Assume, for example, a person purchases a home for $650,000 and then spends $50,000 to renovate the kitchen and add a bathroom. The cost basis of the home, therefore, increases from $650,000 to $700,000. After 10 years of owning and living in the home, the homeowner, who is single and files his taxes as such, ends up selling the property for a price of $975,000. If no capital improvements had been made, the taxable amount for the capital gain would have been $75,000, derived as $975,000 (sale price) - $650,000 (purchase price) - $250,000 (capital gains exclusion). However, because the capital improvement increased the cost basis by $50,000, the taxable amount for the capital gain would be $25,000, calculated as $975,000 - ($650,000 + $50,000) - $250,000.

New York State's rent laws include a provision called the Major Capital Improvements (MCI) program. Dating from the 1970s, it allows landlords to raise rent-stabilized or -controlled building rents by up to 6% annually, to recoup the cost of major capital improvements to those buildings: HVAC system, upgrades, new elevators, etc. In February 2019, two State Legislature members introduced a bill to eliminate the program, charging that the program is too easy for building owners to abuse, by submitting inflated or fabricated claims of expenses. Potential for fraud aside, the MCI program is inherently unfair, other critics charge: A capital improvement is a one-time cost for a landlord, but a rent increase is an ongoing one for a tenant.