The calculation of gain or loss on the sale of your property includes a number of inputs, which will likely include things like your purchase costs, accumulated depreciation (especially if it was a rental), and selling expenses. Also included in this number are your home improvements. Home improvements generally add to the basis of your property, and may be used to lower your gain, or even turn your gain into a loss, putting more money into your pocket when you file for a HARPTA refund!
What defines a home improvement (also referred to as a "capital improvement")? From Hawaii Dept. of Tax - Tax Facts 2010-1 - Understanding HARPTA:
Capital improvements add value to the property and have a useful life in excess of one year, prolong the property's life, or adapts it to new uses. This should not be confused with a repair, which just returns something to its original condition. Capital improvements can include everything from a new bathroom or deck to a new water hearer or furnace. However, this improvement must still be evident when you sell the property.
In addition, this is a description of what is allowable to be reported as an improvement:
If the furnishings are removable without incurring substantial damage to the home, the cost of the furnishings does not increase the basis of the home. For example, the cost of a stand alone refrigerator and drapes cannot be added to the basis of the home...
I say this unequivocally: YOU ARE ENTITLED TO A TAX BENEFIT FOR MAKING IMPROVEMENTS TO YOUR PROPERTY. I really can't emphasize this enough. But there are also important practical and strategic considerations that should be used to balance your expectations.
HARPTA waiver, reduction, and early refund filers are subject to a much higher level of scrutiny by the reviewers when compared to your annual income tax filings. Home sellers who want to use their improvements to add to their basis need to make sure they have an invoice, as well as proof of payment for the improvement to even be considered. The reviewers often demand this, so we ask our clients to provide it to us. If an improvement is not supported by an invoice as well as proof of payment, we generally leave it off.
Recently, a reviewer pushed back on one of our filings. We had added the cost of a fixture to our basis, but his question to us was, "I see an invoice and proof of payment, but how do we know that this wasn't already fully expensed?" If an improvement is classified as an expense and run through the annual profit and loss of the property already, you may not also classify the item as a capital improvement. This would be doubling up on the expense - not allowed. The reviewer made a reasonable point. Of course, we could have answered him by showing detailed ledgers from the year the improvement was made, and showing that the expense in question was not included, but that sort of back and forth will often slow down a refund from being issued. And realistically, few of our clients keep records with that level of detail.
In addition, another thing to think about is how much benefit you'll actually receive from reporting your improvement on your HARPTA filing. For every $1,000 in improvements that are accepted by the reviewers, you'll receive an additional $72.50 in refund - not a lot. Is it worth having your refund delayed in order to put a few hundred more dollars into your pocket?
It's also important to understand that for the sake of the early, tentative HARPTA refund, if you leave out the cost of an improvement in your calculation, it's not as if you lose that tax benefit. You will retain that benefit, and you may still report it on your Hawaii income tax return!
Finally, the most important consideration of all: time. Generally speaking, the more improvements you have, the longer it will take for the State to review it and the longer it will take to get your refund. We're certainly not happy about this - we want all of our clients to get their refund quickly and for the full amount they're owed! But we also realize that we're working within the confines of an imperfect system. So if you ever speak to us and find that we are dissuading you from including improvements in your HARPTA filing, please know that we're doing it to help you get your refund as quickly as possible.
Please call us if you have any questions.