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How I Turned a Flooded Basement Into a Tax Deduction

capital loss deduction

It’s 5 a.m. You get up and walk downstairs. You step off the bottom stair — right onto some carpet that’s cold and wet. Once you flip the light switch, you see more water coming in. And pretty soon, the water is up to your ankles.

That’s what happened to me in January 2010. A sudden thaw resulted in rapid snowmelt and a rising water table that invaded all the homes on my street.

Because I didn’t have flood insurance, I had to pay all the costs. This meant hiring someone to pump the water out, install a sump pump (so it wouldn’t happen again), and remove the destroyed carpet pad. After that, I had to reinstall the carpet (with a new pad) and the baseboards needed repainting.

In the end, it cost me more than $3,000.

With the help of my emergency fund, I was able to pay for the repairs without disrupting my regular spending. Thanks to the way I set up my emergency fund, I even received a capital loss deduction in the process. Here’s how I did it.

Are home repairs tax deductible?

In general, home repairs are not tax deductible. If you’re repairing your home due to damage or keeping up with general maintenance, you can’t deduct the related costs on your taxes. (The story is different when you make substantial improvements to your home and sell it, though.)

Bringing my basement back up to par didn’t count as an improvement. It was a repair. So under normal circumstances, it wouldn’t be tax deductible.

So how did I turn it into a tax deduction? That’s where my emergency fund comes in.

My emergency fund: a taxable investment account

Rather than keep the bulk of my emergency fund in a savings account, I put most of it in a taxable investment account.

I have a two-tiered emergency strategy. The first tier is a high-yield savings account. I keep three to four weeks’ worth of expenses in this account because the money is easy to get to and I can withdraw it immediately if something comes up.

The second tier is a taxable investment account. This is where I keep most of my emergency assets. Every month, a set amount is automatically transferred from my checking account and invested in a stock index fund. The money keeps growing until I need it.

Rather than sitting in an account earning 1% APY, my average annual return over the last eight years has been just over 12 percent. That sure beats letting the bulk of the money sit in a savings account earning practically nothing.

How my tiered strategy works

When my basement flooded, I needed about $1,000 within a couple of days to start paying the bills. The rest of the money was billed later.

Because I needed the money immediately, I withdrew that initial $1,000 from my savings account. Then, I began the process of liquidating some of the shares in my investment account.

The downside to keeping emergency fund money in a taxable investment account is that you can’t access the funds right away. I needed to put in a sell order for some of the shares, then the order needed to settle. After the shares were finally sold and the order was complete, I had to go back to the account and submit a transfer request.

All told, it takes about a week for me to get money from my taxable investment account.

Once I sold enough shares to get $3,000 and the money finally arrived, I deposited $1,000 in my savings account to replace what I withdrew. The rest went into my checking account to pay the rest of the costs associated with the flooded basement.

I kept the automatic investment plan in place, so the $3,000 I withdrew was replaced over the course of a few months.

Finally, because my emergencies have fortunately been few and far between, years go by before I need to call on the account again. In the case of the flooded basement, the $3,000 represented a little less than one-third of my assets in the investment account.

Where does the capital loss deduction come in?

So how did I get a tax deduction out of this? The answer is in the capital loss.

In January 2010, the markets were still recovering from the financial crisis. Because I was selling shares I bought in 2007, I ended up selling them at a loss. In fact, I lost a bit more than $1,000 when I sold those shares.

However, the government allows a capital loss deduction. I was able to deduct that $1,000 loss from my income when I filed my 2010 taxes. I got the money I needed to cover the emergency, I still had plenty left in the account to keep growing, and I ended up with a tax advantage.

It’s never fun to know your investments lost value, but the purpose of the emergency fund is to provide you with money when you need it. Any gains are just an added bonus — and with the taxable investment account, there’s the potential for a lot of added returns.

What if your assets appreciate?

In 2015, I used money from my emergency fund to buy some furniture and appliances after my divorce. This time, I had a gain of close to $700 and I had to pay long-term capital gains tax on that money.

However, because long-term gains are taxed at a favorable rate, I only had to pay 15 percent, instead of my marginal rate of 25 percent. Paying any tax isn’t fun, but once again, I had access to the money I needed when I needed it — and my emergency fund is still intact.

Why this strategy won’t work for everyone

Not everyone loves this strategy. If you can’t stomach the ups and downs of the market, it might not be a good plan for you. Sometimes you will have to sell when the market is down and take a loss. Other times, you may need to pay taxes if you sell for a gain.

If those ideas make you uncomfortable, this might not be for you. There’s nothing wrong with keeping your emergency fund in a standard savings account. But if you want to boost your potential gains and possibly grow your emergency fund faster, this can be a solid strategy to employ.

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Published in Smart Tips for Saving Money, Taxes