Repairs or Improvements?
Of course, repairs! Why bother with some technicalities?
Because if you don’t, the IRS will. Everything you spend to fix the real property is classified is either repairs or improvements. The cost of repairs is a current year expense, fully deductible. The cost of improvements is a capital expenditure, only partially deductible through depreciation.
Let’s look at an example. If, after your tenant moved out, you spent $5,000 replacing various broken things (windows, toilets, handles) and repainting the whole mess – it is a repair. Your tax deduction is $5,000. However, if you spent the same $5,000 on a new roof – it is an improvement. As such, it is subject to depreciation rules: in the first year, you can only deduct less than $180 – out of $5,000 spent! Quite a difference on your tax return!
Obviously, a repair is “better” than an improvement. How do we decide which is which? To do so, we need to answer 3 questions:
- Is it necessary to restore the property to its operational condition?
- Does it increase the value of the property?
- Does it extend the useful life of the property?
If the answer to the first question is “yes”, you have a repair. If the answer to the 2nd or 3rd question is “yes”, it is an improvement. The table below gives you some typical examples of how this test works out.
Repairs |
Improvements |
|
| repainting wall-papering fixing leaks plastering fixing broken windows replacing door locks patching damaged carpet patching vinyl or tile flooring fixing gutters |
replacing entire carpet wall-to-wall replacing roof upgrading plumbing or wiring adding a room or patio putting up a fence paving a driveway kitchen redesign installing central air-conditioning landscaping installing security system insulating attic |
Warning 1
There is a nasty surprise for rehabbers. If expenses that are normally repairs are part of a remodeling project – they are considered improvements and must be depreciated. Working “around” this rule is possible but tricky.
Warning 2
With tax laws, almost nothing is black and white. If the 3-question test above appeared to you unclear, it is. There is a long history of arguments between the taxpayers and the IRS over the interpretation of the rules. Some cases went to courts, and some of those were ultimately won by the taxpayers. In one particular case, a taxpayer was allowed to treat a new roof as a repair. Does it mean you can do it too? Most likely, no! But if you believe that you have some special situation, it may pay off to consult a tax professional knowledgeable in Real Estate.
It seems to me that experienced landlords and contractors are forced to be very clever at “repairing” everything. When the IRS defines a new roof as an “improvement” for the sole purpose of taxing it (IRS “depreciation” is little more than a thinly veiled tax on the front end with the govenment benevolently allowing you to deduct the cost over the next however many arbitrary number of years-never mind the lost purchasing power from inflation over 10+ years), landlords and contractors have little incentive to “improve” anything on their property.
Additionally, many of the IRS definition of “improvements” don’t add intrinsic value to the property-they are merely the normal cost of keeping the building habitable (they are just expensive in one year, e.g. roof replacement once over 30 years or re-running electrical for code and liability reasons). Suggesting that a new roof is an “improvement” because it “extends the useful life” of the property is like suggesting that an oil change is an “improvement” for the truck because it “extends the useful life” of the engine. Without oil the engine freezes and without a new roof the house falls in and collapses.
David, thank you for reading and commenting.
You make good points, but unfortunately you are not yet a Congressman. If you run for the office, I will support you. Maybe you can succeed at improving our atrocious taxation system. Meanwhile, we have to deal with what it is, fair or not. It’s an endless battle between creative taxpayers who try, like you said, to call everything a repair and IRS auditors who try equally hard to disallow these deductions. Sigh.
Michael Plaks