For tax purposes, as well as for potential appreciation of your property, it is very important to understand the difference between making an improvement and making a repair to your rental property. They have different tax implications, as well as different effects on the value of your property.*
What is an Improvement?
An improvement is any type of renovation that will extend the “useful life” of the property. The theory here is that it will add value to the property for years to come and not just in the current tax year. Improvements are generally considered adding something that was not previously there, upgrading something that was existing or adapting the asset to a new use. Improvements are usually more intensive than repairs and usually involve greater cost.Examples of Improvements:
- adding an addition
- adding central air conditioning
- installing a security system
- installing brand new carpet
- replacing an entire roof
- replacing all existing plumbing
- replacing all existing electric
- renovating a kitchen
- replacing all windows
What is a Repair?
A repair is maintenance that is necessary to keep the property in working condition. The IRS defines repairs as those that “do not add significant value to the property or extend its life.” They are reasonable in amount and are necessary to keep the property in habitable condition. Repairs are generally considered restoring an item to its previous good condition.Examples of Repairs:
- refinishing a wood floor
- repainting a room
- repairing a roof
- repairing existing plumbing
- repairing existing appliances
- replacing a doorknob
- replacing a window
- replacing a broken smoke detector
- replacing rotted floorboards
- replacing cracked floor tiles
Can You Deduct Improvements on Your Taxes?
Yes, but the full value cannot be deducted in the year in which they occurred. This is because improvements have a useful life and add value in subsequent years, not just in the year the improvement occurred. Improvements must be capitalized and depreciated according to a set depreciation schedule (it will be different for each asset). You must divide the cost of the improvement over the useful life of the improvement and then take an annual deduction based on the given year's expense.
Example: You performed $5,000 of work on your property. It is considered an improvement. Therefore, you must deduct it over a set depreciation schedule. We will use a depreciation schedule of 10 years. We will assume there is no salvage value, meaning it will be worth nothing after the 10 years. We will also assume straight-line depreciation, meaning the cost will be spread out evenly over the 10 years. Thus, you can claim ($5000/10) an expense of $500 each year for the next 10 years. Assuming you are at a 28% tax rate, you will save ($500*.28) $140 in taxes for the year.
Can You Deduct Repairs on Your Taxes?
Yes, you can deduct the full cost of the repair in the tax year that the repair was completed.
Example: You performed $5,000 of work on your property. It is considered a repair. As a repair, you can deduct the entire expense in the current year. Assume your tax rate is 28%. Thus, you will save ($5,000 *.28) $1400 in taxes.
Improvements vs. Repairs, Which is Better?
One is not necessarily better than the other. An improvement, such as adding an addition, adds value to your property, but the entire cost of a repair, such as fixing a roof leak, can be immediately deducted on your taxes, leaving more money in your pocket.
The ideal situation will vary depending on your needs. Some landlords need to maximize all immediate write-offs because their livelihood is dependent on their yearly rental income. In this scenario, being able to classify an expense as a repair would be beneficial because it would maximize the landlord’s after-tax dollars for the given year. However, if the landlord does not need additional deductions for the given year, extending the life of the depreciation for several years, by classifying the expense as an improvement, could be beneficial.
Many landlords and rental property owners use a loophole by placing a tenant in the property and then performing ‘repairs.’ This allows the landlord to perform more extensive maintenance that may have otherwise been classified as an improvement. With the tenant already living there, the landlord can claim that the work is necessary to keep the tenant satisfied.
For those things that could fall in a grey area between improvements and repairs, it really depends on how comfortable you and your accountant are with defending your claim against IRS scrutiny.
*You should always consult the IRS or a certified accountant to decide what deductions are applicable to your specific situation.