Capital Improvements on a Home: IRS Rules, Basis, and Exclusion

Capital improvements on a home are permanent upgrades that add value, extend the property’s useful life, or adapt it to a new use, and their full cost gets added to your home’s tax basis. A higher basis means a smaller taxable gain when you eventually sell. For most owners, the $250,000 gain exclusion ($500,000 for married couples filing jointly) already covers the profit, but tracked improvements are what protect you when appreciation runs past that ceiling or when the exclusion doesn’t fully apply.

What Counts as a Capital Improvement

The IRS uses a three-part test, drawn from Treasury Regulation section 1.263(a)-3, that practitioners call “BAR.” Work qualifies as a capital improvement if it produces a betterment, an adaptation, or a restoration of the property.¹

A betterment fixes a defect that existed before you bought the home, or materially increases the property’s capacity, strength, or quality beyond its original condition.
An adaptation converts part of the home to a use that is meaningfully different from how the property was used when you acquired it, such as turning a garage into a rental apartment.
A restoration brings a deteriorated component back to working order, or replaces a major structural system like the entire roof or all the plumbing.

Meeting any one of the three is enough. The IRS applies the analysis system by system, so replacing the whole HVAC counts as a restoration even though it is only one part of the house.

Repairs That Don’t Count

This is where most homeowners get tripped up. A repair keeps your home in its current condition without making it better, bigger, or fundamentally different. Patching a leaky pipe, repainting a room, fixing a cracked window, or replacing a few shingles after a storm are all repairs. The IRS has confirmed that routine work like painting walls and refinishing floors is not a capital improvement.²

Repairs do not increase basis. You spend the money, the home stays functional, and that is the end of it for tax purposes. The line blurs when a repair is folded into a larger project. Replacing a few bathroom tiles is a repair. Gutting the bathroom and installing new fixtures, plumbing, and tile is a capital improvement. Scale and context decide which side of the line the project sits on.

Common Examples

IRS Publication 551 lists the categories that qualify, and Publication 523 gives homeowner-specific examples for people preparing to sell.³ Projects that typically qualify include:

Additions: new bedrooms, bathrooms, a second story, an attached garage, or a deck that expands the footprint.
Roof and exterior: replacing the entire roof, installing new siding, adding storm windows and doors.
Interior remodels: a full kitchen renovation, new bathroom construction, or replacing carpet with permanent hardwood flooring.
Major systems: central air conditioning, a new furnace, rewiring the electrical panel, or replacing the plumbing throughout the house.³
Landscaping and site work: paving a driveway, building a retaining wall, installing a fence, or adding a permanent swimming pool.
Accessibility features: ramps, widened doorways, and support bars installed permanently into the structure.

Solar panels, geothermal heat pumps, and other energy-efficient systems also qualify and are added to basis. The federal tax credits for these installations under Sections 25C and 25D expired after December 31, 2025, so projects completed in 2026 no longer offset costs through those credits, though the full installation cost still increases basis.⁴

How Improvements Change Your Tax Basis

Your home’s tax basis starts with what you paid for it. Original cost basis includes the purchase price plus certain settlement costs like title insurance, legal fees, recording fees, and transfer taxes.⁵ Every qualifying capital improvement you make while you own the home gets added on top.

The arithmetic is straightforward. Buy the home for $300,000, pay $5,000 in qualifying closing costs, then spend $40,000 on a kitchen remodel and $15,000 on a new roof, and your adjusted basis climbs to $360,000. When you sell, subtract the adjusted basis from the amount you received (after selling expenses) to determine your gain or loss.⁵ A higher basis produces a smaller gain. That is the whole point of tracking improvements.

What Can’t Go Into Basis

One rule catches DIY homeowners off guard: you cannot include the value of your own labor. If you spend 200 hours building a deck yourself, only the lumber, hardware, and any hired help count. The IRS is explicit on this.³ Routine maintenance and repairs never add to basis either, however much they add up to over the years.

What Reduces Basis

Some events cut in the other direction. Insurance reimbursements for casualty losses like fire or flood damage reduce your basis, as do any casualty loss deductions you previously claimed.⁵ A $30,000 storm-damage payout drops your basis by $30,000 even if you spent the money rebuilding.

Depreciation reduces basis too, and this matters if you have claimed a home office deduction under the regular method. The IRS uses the greater of what you actually deducted or what you were required to deduct, and the depreciated amount is later “recaptured” and taxed at a maximum rate of 25% when you sell, separately from the regular capital gains rate on the rest of the profit.⁶ The simplified home office method avoids the hit; under that option, depreciation is treated as zero and basis is not reduced.

Why Basis Still Matters With the $250,000/$500,000 Exclusion

Section 121 lets you exclude up to $250,000 of gain if you file as a single taxpayer, or up to $500,000 if you file jointly, assuming you owned and used the home as your primary residence for at least two of the five years before the sale.⁷ Those figures are flat and don’t index for inflation.

Improvements become critical when the gain runs past the exclusion. A couple who bought for $200,000 twenty years ago and sells for $900,000 has a $700,000 gain before improvements. With $150,000 in tracked capital improvements, their adjusted basis rises to $350,000 and the gain falls to $550,000. After the $500,000 exclusion, only $50,000 is taxable. Without the records, they owe tax on $200,000. Anything above the exclusion is taxed as a long-term capital gain at 0%, 15%, or 20% depending on income.⁸

Records to Keep

Good records are the only thing standing between you and a higher tax bill. The IRS expects documentation showing the cost of each improvement, what the work was, and when it was completed.⁹ For most homeowners that means contractor invoices, signed contracts, material receipts, and proof of payment like canceled checks or bank statements.

You might own the home for 15 or 30 years before selling, and receipts from a year-three kitchen remodel disappear easily. Start a dedicated file, physical or digital, the day you close, and add to it every time you pay a contractor or buy materials. Building permit applications and inspection reports back up the fact that the work happened.

Electronic records are acceptable if the storage system keeps them accurate, prevents unauthorized changes, and can produce legible copies on request.¹⁰ Scanning receipts to a cloud folder with an organized structure meets that standard. A blurry phone photo buried in an unsorted camera roll will not hold up if you need to prove a $20,000 improvement at audit.

Reporting the Sale and the Cost of Overstating Basis

If your gain is fully covered by the Section 121 exclusion and you did not receive a Form 1099-S from the closing agent, you do not need to report the home sale on your tax return at all.⁵ Reporting is required if the gain exceeds the exclusion, if you received a Form 1099-S, or if you choose to report an excludable gain anyway.¹¹

When you do report, the transaction goes on Form 8949 with the sale proceeds, adjusted basis, and any adjustments; the totals carry to Schedule D of Form 1040.¹² Selling expenses like real estate commissions, advertising fees, legal costs, and transfer taxes reduce the amount realized before it is compared to basis.⁵

Do not inflate basis to shrink a taxable gain. Overstating basis can trigger the accuracy-related penalty, a flat 20% addition to any underpaid tax, which the IRS applies when the claimed basis is 150% or more of the correct amount.¹³ Honest, well-organized records are the simplest defense.

1
eCFR. 26 CFR 1.263 – Capital Expenditures
2
Internal Revenue Service. Tangible Property Final Regulations
3
Internal Revenue Service. Publication 551 (12/2025), Basis of Assets
4
Internal Revenue Service. FAQs for Modification of Sections 25C, 25D, 25E, 30C, 30D, 45L, 45W, and 179D
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Internal Revenue Service. Publication 523 (2025), Selling Your Home
6
Internal Revenue Service. Depreciation and Recapture
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Office of the Law Revision Counsel. 26 U.S. Code 121 – Exclusion of Gain From Sale of Principal Residence
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Internal Revenue Service. Topic No. 409, Capital Gains and Losses
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Internal Revenue Service. What Kind of Records Should I Keep
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Internal Revenue Service. Revenue Procedure 97-22
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Internal Revenue Service. Topic No. 701, Sale of Your Home
12
Internal Revenue Service. 2025 Instructions for Form 8949 – Sales and Other Dispositions of Capital Assets
13
Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments