It is important to understand what qualifies as making a capital improvement to your investment property and what instead qualifies as making a repair or minor upgrade so you claim the correct tax break.
Deducting Capital Improvements
A capital improvement is a property update that extends the “useful life” of the property. This is defined as the period of time during which the asset serves a useful purpose. Wear and tear can factor in because an asset might be more useful and accomplish more initially than after years and years of use. Improvements are usually more extensive than repairs and they usually involve greater cost. They include adding something to an existing building, such as a room or a wing, or making major upgrades to features that already exist. They might also adapt the asset to a new use. Improvements aren’t just short-term fixes. They add value to the property for years to come.
Examples of Capital Improvements
Adding an additionAdding central air conditioningInstalling a security systemInstalling brand new hardwood flooringReplacing an entire roofReplacing all existing plumbingReplacing existing electricRenovating a kitchenRenovating a bathroomReplacing all windowsAdding a deckBuilding an in-ground pool
Deducting Repairs to Your Investment Property
A repair is simply necessary maintenance that keeps the property in habitable and working condition. It doesn’t add significant value to the property or extend its life. An asset is generally restored to its previous good condition when it’s repaired. It’s not improved upon. Repairs can usually be completed for a reasonable amount of money. Replacement of broken appliances is usually also considered to be a repair.
Examples of Property Repairs
Refinishing a Wood FloorRepainting a RoomRepairing a RoofRepairing Existing PlumbingRepairing Existing AppliancesReplacing a DoorknobReplacing a WindowReplacing a Broken Smoke DetectorReplacing Rotted FloorboardsReplacing Cracked Floor TilesUpdating Old Appliances
How To Deduct Improvements on Your Tax Return
You can deduct the cost of improvements made to your investment property, but you can’t deduct the full value of the improvement in the year it’s made. Improvements must be capitalized and depreciated according to a set depreciation schedule. The schedule used depends on the particular 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. You would typically use the Accelerated Cost Recovery System (ACRS) if you acquired the asset and put it in service before 1987. Otherwise, use the Modified Accelerated Cost Recovery System (MACRS).
An Example of Deducting an Improvement
Let’s say you’ve made a $5,000 improvement to your rental property. You must deduct it over a set depreciation schedule. We will use a depreciation schedule of 10 years. We’ll assume there’s no salvage value so it will be worth nothing after this 10-year period. We’ll use straight-line depreciation so the cost will be spread out evenly over the 10 years. You can deduct $500 each year ($5,000 divided by 10) for the next 10 years. So your taxable income is lowered by $500 each year when you file your taxes.
How To Deduct Repairs on Your Tax Return
You can deduct the full cost of a repair in the tax year that the repair was completed because it’s merely intended to restore the asset to its previous condition. The deduction would be subtracted from the rental income received in the same period.
An Example of Deducting a Repair
Now let’s say that you performed a repair on your rental property that cost you $5,000. You can deduct the entire expense in the current year because it’s a repair. That lowers your taxable income by $5,000.
Improvements vs. Repairs: Which Is Better?
The decision to deduct the cost of work as an improvement or repair will depend on your needs and on the nature of the work. Some landlords need to maximize all immediate write-offs because their livelihoods depend on their yearly rental incomes. Being able to classify an expense as a repair would be beneficial in this case because it would maximize your after-tax dollars in the given year. But extending the life of the depreciation for several years by classifying the expense as an improvement could be beneficial if you don’t need additional deduction in that first year. And, of course, it depends a great deal on the nature of the work that’s been done. Many improvements simply don’t qualify as repairs. You’re not permitted to classify them as such so you can take the entire deduction in the year you spend the money. As for costs that fall into a gray area between being classified as improvements or repairs, it really depends on how comfortable you and your accountant are with defending your claim against IRS scrutiny.
