A capital improvement is a permanent structural change or restoration that adds value to a property or prolongs it's useful life.
A capital improvement is the addition of a permanent structural change or the restoration of some aspect of a property that will either enhance the property’s overall value, prolongs its useful life, or adapt it to new uses. Individuals, businesses, and cities can make capital improvements to the property they own. Often capital improvements are given favorable tax treatment and may be exempted from sales tax in certain jurisdictions.
IRS Publication 523 outlines the official definition of a capital improvement as any improvement made to a property that adds value to the home, prolongs its useful life, or adapt it to new uses. You add the cost of additions and improvements to the basis of your property.
Examples of residential capital improvements include adding or renovating sections of the house, building in new appliances, and replacing the flooring or roof.
One example of a capital improvement and how it needs to be treated would be converting the garage into another bedroom with an ensuite. By doing this you are increasing the value of the property and the amount of rent it can generate as a rental.
In this example, the renovation costs $50,000. Because this is an addition, and thus a capital improvement the expenses of the renovation can’t be deducted, instead the cost of the work gets added to the cost basis of the property and depreciated. If the house originally cost $450,000, after the addition its cost basis would be adjusted to $500,000.
It’s a good idea to consult a licenced professional when working out the adjusted cost basis and depreciable amount to ensure it is done correctly and you don’t end up overpaying your taxes.
Examples that constitute capital improvements include:
A repair to a property is an expense that is used to restore a part of the house or item inside it to its original condition. For example, repairing a tap by replacing the washer, repainting surfaces, repairing an old air conditioning unit.
A capital improvement on the other hand is a lasting upgrade to a property that adds value to the asset. Often this involves structural work and often is part of the property so that the removal of it would cause significant damage or decrease in the value of the property itself.
Knowing the differentiation is important as repairs and capital improvements must be treated differently. The expense associated with repairs can be deducted against rental income at the end of the year to reduce the investor’s tax liability. On the flip side, the expense of a capital improvement cannot be deducted but must instead be added to the cost basis of the property and depreciated.
The costs and expenses associated with capital improvements should be carefully tracked. Additionally, all supporting receipts and documentation associated with the work should be recorded as the IRS sets specific standards and restrictions on what qualifies as an expense and what qualifies as a capital improvement.
This is one reason having a rental accounting system like Landlord Studio is so valuable. It allows you to easily and efficiently track income and expenses in real-time via the app, or on desktop. Additionally, with our receipt tracker and bank feed integration you can minimise the amount of manual data entry required, saving time and reducing the potential for costly errors in your accounting.
In Landlord Studio you should simply mark each expense associated with the capital improvement as a capital expense. This allows you to run comprehensive reports for all your capital expenses to give you a summary and total of all costs which can be depreciated.