Improving Your Home? Here's Why You Really Need to Keep Records

One of the benefits of owning a home rather than renting one is that eventually, you may be in a position to sell your home at a nice profit. Granted, that point may come after many years of paying a mortgage, covering property taxes, and forking over lots of money for repairs. But eventually, your home may be worth a lot more than what you paid for it, which puts you in a good financial position once you're ready to sell.

But if you're gearing up to sell a home, you'll need to think about the tax implications involved. Just as the IRS is entitled to a piece of your income when you make money from a job or investments, so too might you have to pay tax on the sale of your home if you're making a profit.

If you keep good records of your home improvements, you might manage to whittle down that tax bill -- or even eliminate it altogether.

How the capital gains tax exclusion works

When you sell a home at a price that's higher than what you paid for it you're subject to capital gains tax, the same way you are when you sell a stock or bond at a profit. But in the context of a primary home, the IRS throws you a bone in the form of the capital gains tax exclusion.

Here's how it works. If your tax-filing status is single, you can exclude up to $250,000 in capital gains on the sale of a home (as long as you've owned and lived in the home as your primary residence for at least two of the past five years). If your status is married filing jointly, that exclusion rises to up to $500,000.

So, let's say you and a spouse own your home jointly. If you bought it for $300,000 and it's now worth $900,000, you're making a $600,000 profit. Thankfully, you don't have to pay taxes on that entire $600,000 gain, because $500,000 of it qualifies for the exclusion. But there's still another $100,000 you might face a tax bill on.

How home improvements factor in

Home improvements are added to your cost basis when calculating your capital gains tax exclusion for a home sale. In the example above, let's say you bought your home for $300,000, but you also paid $100,000 to put on an addition to your property. That raises your home's cost basis to $400,000. If you and your spouse then sell it for $900,000, you won't have to pay capital gains tax on that sale.

That's why it's so important to keep solid records of the improvements you make. That way, you'll know what specific costs to factor in at the time of your home sale.

One thing you may want to do is keep an electronic record of scanned paperwork and receipts documenting your various improvements. There may be many smaller ones you make over time, but anything that's an improvement to your home -- not a repair -- counts. So if you put in a deck, that qualifies. If you fix your fence, it probably doesn't count, because you're simply repairing an item that was already part of your home.

If you're gearing up to sell your home and you aren't sure which projects count as improvements versus repairs, consulting an accountant is your best bet. But either way, you'll need records of the work you've done to set yourself up for that tax break. Make sure to set up a system early on that makes home improvement spending easy to track.