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ContinueWhat's the difference between capital improvements and repairs? And how do each need to be accounted for according to the IRS guidelines?
Written by
Ben Luxon
PUBLISHED ON
18
Dec
2023
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?
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.
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.
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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.
The IRS indicates that the following examples constitute a real property capital improvement:
Examples include:
Determining whether expenses qualify as improvements, repairs, or maintenance is crucial for landlords, and there are key distinctions to consider:
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.
Generally speaking, painting a rental property is not considered a capital improvement. However, according to the Internal Revenue Service, there are some scenarios painting might be.
Consider this scenario: Your rental property requires substantial attention. You invest significantly in replacing the roof, installing new aluminum gutters, fitting all-new energy-efficient windows, upgrading the furnace and air conditioning unit, and undertaking a complete interior and exterior paint job.
Painting the property in this scenario would be deemed part of a comprehensive restoration where major property components have been replaced. As such it would qualify as capital improvements and would be depreciated over a 27.5-year period using the straight-line depreciation method.
On the other hand, if the property's components are in good condition, and your sole intention is to paint the residence, the painting cost generally doesn't meet the IRS capitalization rules for a capital improvement. However, it remains a deductible repair expense and can be deducted in full in that year.
Real estate investors can reclaim the value of the property (excluding the value of the land) over what the IRS deems the assets ‘useful life’. Residential property can be depreciated over a period of 27.5 years and commercial property over 39 years. For example, if you purchase a residential investment property for $250,000 with a land value of $50,000. You would then be able to claim an annual depreciation amount of $7272 ($200,000/27.5) against your taxable rental income.
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.
The capital improvement tax deduction for residential rental property investment refers to the IRS-approved allowance for landlords to claim certain expenses as capital improvements. These expenses involve substantial enhancements or replacements to elements within a rental property that contribute to its long-term value or extend its useful life.
Unlike ordinary repairs and maintenance, which are deductible in the year they're incurred, capital improvements are depreciated over time, typically across 27.5 years for residential properties unless a cost segregation is used. This means landlords need to spread the deduction of these expenses over the assets expected lifespan, reducing taxable income each year.
However, not all improvements qualify as capital improvements, and the IRS has specific guidelines regarding what can be considered as such. It's crucial for property investors to understand rental property tax deductions to maximize tax benefits while staying compliant with IRS regulations.
Differentiating between maintenance, repairs, and capital improvements is crucial in navigating tax implications for property owners. While expenses for repairs and maintenance can typically be claimed as deductions on annual taxes, costs for improvements must be amortized over the improvement's lifespan.
This distinction is vital for managing business operations and understanding how expenses impact taxes. Repairs and maintenance fall under operational expenses (OpEx) for tax filing, while improvements are categorized as capital expenditures (CapEx). However, determining which expenses fit into these categories can sometimes be unclear, leading to confusion.
To navigate this complexity, the IRS has established Tangible Property Regulations. Despite this guidance, uncertainties may persist, making it wise to consult an accountant for clarification on expenditures that straddle multiple categories within construction portfolios.
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.
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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.
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