Maintenance activities can include everything from repainting, lightbulb replacements, and general housekeeping to more expensive maintenance tasks like elevator repairs, landscaping, and pool cleaning.
On top of these ongoing routine maintenance tasks, there are major repairs to consider. These generally require more substantial commitments of time and funds and can arise unexpectedly at any time. This includes things like plumbing emergencies and major refurbishments or upgrades.
The wide range of maintenance expenses does not all fit under one taxable bracket. They 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 expenses / improvements and operating expenses, ie. repairs, and how each need to be treated and accounted for so that they can be accurately deducted against taxable income according to the IRS guidelines.
A capital improvement is a durable lasting upgrade, adaptation, or an enhancement of the property which significantly increases the value of the property. Often this involves structural work or restoration.
The cost of capital improvements cannot be deducted as an expense at the end of the year. Instead, they need 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 repair is any maintenance work carried out on the asset throughout its lifetime which returns it to the original value. 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.
Both routine and preventative maintenance, ie. work carried out before an asset “breaks”, are both generally deemed as repairs if they are 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.
Essentially, capital improvements are made to increase the value of an 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?
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, they 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 could 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.
This is a simplified example and can become complex. It is recommended that you seek qualified advice from a licensed tax professional for further information about your individual situation.
Landlords need to carefully consider how they categorize maintenance work. Depending on whether it’s classified as a capital expense 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.
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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Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks.
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