It is important to understand what qualifies as making a capital improvement to your property and what instead qualifies as making a repair or minor upgrade. Improvements have a much greater impact on the value of your property than repairs, and they are calculated quite differently when it comes to filing your taxes. Learn how to deduct improvements vs. repairs on your taxes.*
Definition of a Capital Improvement
A capital improvement is a property update that will extend the “useful life” of the property. The thinking here is that it is not just a short-term fix, rather it is something that will add value to the property for years to come.
Improvements are usually more extensive than repairs and usually involve greater cost. Improvements include:
- Adding something that was not previously there
- Upgrading something that was existing or
- Adapting the asset to a new use
Examples of Improvements:
- Adding an Addition
- Adding Central Air Conditioning
- Installing a Security System
- Installing Brand New Hardwood Flooring
- Replacing an Entire Roof
- Replacing All Existing Plumbing
- Replacing All Existing Electric
- Renovating a Kitchen
- Renovating a Bathroom
- Replacing All Windows
- Adding a Deck
- Building an In-ground Pool
Definition of a Repair
A repair is necessary maintenance to keep the property in habitable and working condition. The IRS defines repairs as those that “do not add significant value to the property or extend its life.”
When something is repaired, it is generally restored to its previous good condition, not improved upon. Repairs can usually be completed for a reasonable amount of money. Replacements of broken appliances are usually also considered as repairs.
Examples of Repairs:
- Refinishing a Wood Floor
- Repainting a Room
- Repairing a Roof
- Repairing Existing Plumbing
- Repairing Existing Appliances
- Replacing a Doorknob
- Replacing a Window
- Replacing a Broken Smoke Detector
- Replacing Rotted Floorboards
- Replacing Cracked Floor Tiles
- Updating Old Appliances
How to Deduct Improvements on Your Taxes
You can deduct improvements made on your property, however you cannot deduct the full value of the improvement in the year the improvement occurred. This is because an improvement adds value to your property for years to come, not just in the current year.
Therefore, improvements must be capitalized and depreciated according to a set depreciation schedule (it will be different for each asset). You must divide the cost of the improvement over the useful life of the improvement and then take an annual deduction based on the given year's expense.
Example of How to Deduct an Improvement
You made an improvement worth $5,000 to your property. Therefore, you must deduct it over a set depreciation schedule. We will use a depreciation schedule of 10 years.
We will assume there is no salvage value, meaning it will be worth nothing after the 10 years. We will also assume straight-line depreciation, meaning the cost will be spread out evenly over the 10 years.
Therefore, you can claim ($5,000/10) an expense of $500 each year for the next 10 years. Assuming you are at a 28 percent tax rate, you will save ($500*.28) $140 in taxes for the year.
How to Deduct Repairs on Your Taxes
A repair is made to restore an item to its previous condition. Therefore, you can deduct the full cost of the repair in the tax year that the repair was completed against rental income received in the same period. Sometimes, losses incurred by repairs may be carried over to subsequent years.
Example of How to Deduct a Repair
You performed a repair on your property worth $5,000. As a repair, you can deduct the entire expense in the current year. Assume your tax rate is 28 percent. Thus, you will save ($5,000 *.28) $1,400 in taxes.
Improvements vs. Repairs, Which Is Better?
One is not necessarily better than the other. An improvement, such as adding an addition, adds value to your property, but the entire cost of a repair, such as fixing a roof leak, can be immediately deducted on your taxes, leaving more money in your pocket.
The ideal situation will vary depending on your needs. Some landlords need to maximize all immediate write-offs because their livelihood depends on their yearly rental income. In this scenario, being able to classify an expense as a repair would be beneficial because it would maximize the landlord’s after-tax dollars for the given year. However, if the landlord does not need additional deductions for the given year, extending the life of the depreciation for several years, by classifying the expense as an improvement, could be beneficial.
Many landlords and rental property owners use a loophole by placing a tenant in the property and then performing "repairs." This allows the landlord to perform more extensive maintenance that may have otherwise been classified as an improvement. With the tenant already living there, the landlord can claim that the work is necessary to keep the tenant satisfied.
For those things that could fall in a gray area between improvements and repairs, it really depends on how comfortable you and your accountant are with defending your claim against IRS scrutiny.
*You should always consult the IRS or a certified accountant to decide what deductions are applicable to your specific situation.