What's the difference between capital improvements and repairs? And how do each need to be accounted for according to the IRS guidelines?
Capital improvements and repairs can make up a substantial ongoing cost for landlords. However, the expenses associated with each need to be treated differently, with regular maintenance immediately deductible, whereas capital improvements need to be depreciated.
Generally speaking, maintenance and repairs can include everything from repainting, lightbulb replacements, and general housekeeping to more expensive maintenance tasks like elevator repairs, landscaping, and pool cleaning.
The wide range of expenses need to be split out into “maintenance” costs, which are operating expenses covering ongoing repairs and maintenance, and “capital improvements” or capital expenses, which are expenses associated with what the IRS deems an improvement to the property.
In this article, we explore the difference between capital improvements vs repairs, and how each needs to be treated and accounted for so that they can be accurately deducted against taxable income according to the IRS guidelines.
Essentially, capital improvements are improvements made to a property that increases the value of the asset. In this scenario, it could be something like converting the attic into an en suite bedroom or the garage into a separate apartment.
If something is replaced, even if the original is irreparable, this counts as a capital improvement. For example, the roof has a leak and it is deemed necessary to replace the whole roof, this would be a capital improvement.
When determining whether a maintenance job is a capital improvement or a repair, ask yourself does it add value to the property beyond that of its original value? or does it simply return value to the property?
When thinking about capital improvements vs repairs you need to have a clear understanding of the definitions of each.
A capital improvement is a durable lasting upgrade, adaptation, or enhancement of the property which significantly increases the value of the property. Often this involves structural work or restoration.
A repair on the other hand includes both routine and preventative maintenance, ie. work carried out when an asset “breaks” or before, so long as the work is carried out to restore the asset to the original condition. This includes action taken to prevent further deterioration and to replace or substitute a component at the end of its “useful life”. A maintenance task cannot be deemed a repair if it improves upon that original condition.
The reason knowing what a capital improvement is vs a repair is that the expenses need to be treated differently. The cost of capital improvements cannot be deducted at the end of the tax year like regular repair expenses. Instead, the cost needs to be added to the cost basis of the property and depreciated. The benefit of this is that it can reduce the tax hit associated with capital gains and depreciation recapture when the property is sold.
A capital improvement would include major work such as refurbishing the kitchen converting a room or attaching a conservatory. A repair on the other hand is general maintenance, for example, repairing a tap, repainting surfaces, fixing the air conditioning, or maintenance on appliances. The cost of repairs and maintenance can be deducted at the end of the tax year.
Yes. For example, you might call a plumber out for what appears to be a minor issue, a leaky pipe. After reviewing the issue, the plumber informs you that the issue is substantial with damages to various hard-to-reach pipes. They will need to replace an extensive section of pipes and in the process will need to take up the whole kitchen floor.
While the maintenance or replacement of the pipes to bring them back to the original standard would have been a repair, the replacement of the whole kitchen floor would likely be a capital improvement.
The term “useful life” refers to the useful lifespan of an asset, the length of time the system or equipment is expected to function properly. All of the building’s assets such as the security systems have an expected useful life, as does the building as a whole (residential rental property is deemed to have a useful life of 27.5 years).
The useful life can be affected by several external factors, such as wear and tear, or the environment, and you must know the useful life of an asset so that you can accurately track the expenditure.
A cost basis is the original cost of the asset. A capital improvement can’t be deducted as a regular expense. Instead, it should be added to the cost basis of the property as a whole and depreciated.
For the capital improvement to be added to the cost basis of the property it must be a permanent fixture so that removal would cause significant damage or decrease the value of the property.
In the same vein, repairs and maintenance can’t be attached to the cost basis of the property unless they are part of a larger improvement in which case they are similarly deemed as a capital improvement.
Renovations that are necessary to keep a home in good condition treated as regular maintenance and should be deducted as expenses at the end of the tax year. Examples of such non-qualifying repairs, according to the IRS, include painting walls, fixing leaks, or replacing broken hardware.
Capital gains are the taxable increase in the value of an asset. For example, you buy a property for $200,000 and sell it later for $250,000 you would have a capital gain of $50,000.
However, in addition to improving the home, capital improvements also increase the cost basis of the structure (though not the land) as we mentioned above. The expenses incurred upon making the improvements are added to the amount the owner paid to buy or build the property.
What this means is that if you spent $20,000 on capital improvements over the 10 years you owned the rental property, the adjusted cost basis, the adjusted original cost basis of the property would be $220,000 as supposed to $200,000. If you then sold the property at $250,000 you would then only have a taxable capital gain of $30,000.
Landlords need to carefully consider how they categorize maintenance work. Depending on whether it’s classified as a capital improvement or operating expense the expenses will be treated differently. To get it right, consider the value of the asset, the intended goal of the work to be performed, the scope of work, the actual result, and its impact on the asset’s value, depreciation, and equity return.
It’s also important to carefully and accurately track and record all expenses, whether they’re capital improvements or regular maintenance. Applying the correct expense categorization to outgoings isn’t always easy however, doing so will ensure you make the most of the deductible expenses and could save you tens of thousands of dollars in the long run.
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We hope you found this article interesting! However, do note that it should not be used as a substitute for competent legal and/or other advice from a licensed professional.