By Betsy Schiffman, Forbes

Expecting a tax refund this year? Millions of Americans will be getting a check back from the Internal Revenue Service this year, and, as of April 4, average refunds were up 5% to $2,100. What are you going to spend your windfall on? A trip to Maui, paying off your credit card bills or retiling your bathroom?

While most people would probably prefer to opt for the Maui trip, the majority have more pressing needs for their refunds. According to the Cambridge Consumer Credit Index, a monthly survey that gauges consumer sentiment about credit, 68% of Americans who have received a tax refund, or who anticipate receiving a refund, plan to spend it on "everyday items or (paying) bills."

However, if you're all square with American Express or your mortgage company, the smartest way to spend your refund check is by investing it back into your home.

Tax savings come later
Not only is their home most people's single largest asset -- and keeping it in good repair invariably improves its value -- but spending money on certain home improvements now could lead to tax savings down the road.Check out your options.
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It is important to understand that these tax savings will be realized only if and when you sell your home. After you sell, capital gains taxes may be reduced. Be warned: Not all home improvements have tax benefits, so visit the IRS's Web site and look for Publication 523, or check with your accountant before you call in the contractors. Only permanent improvements, not temporary repairs, count toward the adjusted basis -- the amount of money you spent buying and improving the property -- of your property.

For example, if you pay to repair a hole in an existing roof, the IRS says that money is not deductible. But if you have an entirely new roof put on, when it comes time to sell, you can add the cost of the new roof to your home's adjusted basis.

It works like this: If you bought your home for $100,000 in 1984 and spent $25,000 adding a new family room and bedroom, the basis (the amount you invested in your property) increases to $125,000. Because the IRS taxes the profits from a home sale if it is $500,000 or more ($250,000 if you are single), if you sell your house 20 years later for $700,000, you will be taxed only on the $75,000 you gained from the sale. Had you not spent the $25,000 on improvements, you would be taxed on the $100,000 gains you made over the $500,000 tax-free gains.

Sorting out the permanent improvements
The IRS is understandably particular about which improvements can be included in the basis of your property, and which improvements are cosmetic or are merely repairs (in those cases, the home owner absorbs the costs). In the table below are examples of renovations the IRS considers permanent improvements, the costs of which can be included in the adjusted basis of your home.

What wouldn't count? Paint jobs, window cleaning, carpeting, fixing gutters and repairing leaks or broken window panes. (The exception is when such repairs are made as part of an extensive remodeling or restoration of your home.) Be sure to keep records of all improvements to prove your home's adjusted basis.

"Generally, the kind of improvements the IRS is talking about are things that are not easily replaceable, that might cause damage to the property to remove," says Kevin Ondik, a tax partner at Friedman, Alpren & Green, a New York accounting and consulting firm. "An in-ground hot tub is permanent, while an above-ground tub is not. As a general rule, if it's a capital improvement, you don't have to pay sales taxes. If it's not a capital improvement, you often do. That's often a good way of telling whether it qualifies."

Of course, some of these jobs are pretty big, and, depending on its size, your refund check may only go toward a down payment. There are, however, small things you can do to improve the quality of your home, and the total cost could be near or around the $2,000 refund.

We consulted with Monique Lafia and Chris Arvin of Lafia/Arvin, a Santa Monica, Calif.-based design company, for suggestions on home improvements in a $2,000 budget. Some small renovations can be paid for with the refund alone, but for many jobs, the refund is just enough to get it started. Here is what they told us:

Remodel the bathroom
If you focus on a small room, such as the bathroom, you can remodel the whole thing for around $2,000 to $2,500. Chris Arvin suggests you buy quality floor tile and have it installed, and also purchase a new vanity and a stone top, for about $2,500. If you paint the bathroom, too, which could cost about $300, it might look like a completely new room.

Intall central air conditioning system
It may not be sexy, but it could certainly make your home more comfortable, and the costs will likely be recouped when you sell the property. Plus, the IRS allows you to include the cost of a central air conditioner in the adjusted basis of your property. A quality central air-conditioning system could cost between $1,500 and $3,000, but it only counts if it's a central system. An individual unit would not be included in the adjusted basis.

Replace windows
In older houses where window frames let cool air in, this option might be especially appealing. "Replacing a window in a room wouldn't cost that much," says Chris Arvin. "You could buy double-paned windows, which are more efficient than the metal-frame windows, and it could cost about $900 a window. And it's a nice thing to do. If you replaced a few windows in a room, it might cost about $3,000." The IRS also considers storm window replacements "improvements."

Consider fine art
Monique Lafia and Chris Arvin say a nice painting can make a world of difference in a home and could serve as a nice investment. William Goetzmann, a professor of finance at the Yale School of Management, says that although a painting is an inherently risky purchase, it is quite possible to see a return on your investment.

"Of all the things you could spend your refund on, art is probably the lowest on the list--unless it's for your own enjoyment or appreciation," Goetzmann says. "Having said that, the long-term capital appreciation on paintings over the 20th century has been positive. We often see long periods between purchases and sales -- sometimes generations or more -- so it may be OK if you're looking for a long-term source of enjoyment that you can pass on to your family."

Replace cabinets or counters
Replacing an old cabinet or counter that is 20 years old may not cost much, but it can make a big difference. While $2,100 won't get you too far, it's a start, or it may allow you to replace the existing cabinets or counters in a small room, like the bathroom or the laundry room.

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