The cost of repairs that you make to your rental property is deductible in the year paid. On the other hand, improvements on the same property are capital in nature, and their cost must be written off through depreciation deductions spread over the applicable recovery period.
In most cases, you may pay less current taxes by classifying the expenditure as a repair and taking a current deduction, rather than by capitalizing the expense and recovering the cost by way of depreciation.
Since most taxpayers want to maximize deductions to taxable earnings,
most taxpayers are aggressive when classifying expenditures as repairs.
Knowing this, it should be no surprise the IRS will pay close attention
to repair and maintenance deductions claimed on your tax return.
“A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life.”
“An improvement adds to the value of property,
prolongs its useful life, or adapts it to new uses.”
The Department of the Treasury, which is responsible for setting up formal rules and regulations for enforcing tax law, distinguishes between repairs and improvements in Reg. Section 1.162-4 as follows:
“cost of incidental repairs which neither materially
add to the value of the property nor appreciably prolong its life, but
keep it in an ordinarily efficient operating condition, may be deducted
as an expense... repairs in the nature of replacements, to the extent
that they arrest deterioration and appreciably prolong the life of the
property, shall be capitalized and depreciated”
In determining whether expenditures are capital in nature or are expenses that offset operating income, it is necessary to consider why the expenditures were made. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use.
Problems may arise when the items which are claimed to be repairs are expended as part of a general plan of improvement, restoration, or betterment of the property. When implementing a general plan of rehabilitation and permanent improvement of a property, expenditures which are part of this general plan, and which might otherwise be deductible expense for repairs, may become a disallowed deduction. That is, they cannot be expensed but instead must be capitalized and written off over time via depreciation deductions.
Therefore, if you will be making expenditures which might otherwise be deductible as repairs, it may be best not to undertake them at the same time that other more major expenditures are contemplated. If these repair-type expenditures are claimed as a deduction at the same time that substantial capital improvements are taking place or when there is a general plan of renovation of the building, a deduction is more likely to be denied.
You might even consider incurring these expenses in a different tax year. It is also a good idea to keep all records that will help you prove that the repairs claimed are separate from the extensive improvements being made. In general, the larger the expenditure, the more likely the government will consider it a capital improvement versus an expense.
If a repair was not designed to increase the value of the property, prolong its life, or adapt it to a different use, a current deduction will likely be allowed regardless of the size of the expense. In other words, the mere fact that the cost of the repair was substantial does not disqualify the deduction for a repair which otherwise would qualify.
When a broken or damaged item is replaced by a new one, the fact that the new item may have a useful life of more than one year will not necessarily bar deduction of its cost as a repair expense provided that the new item itself does not prolong the life or increase the value of the basic property.
Capital expenditures are amounts incurred to add to the value of the property or to substantially prolong the useful life of property or to adapt the property to a new or different use. Costs which improve a property’s appearance and increase its value are also considered capital improvements. Expenditures for items that were originally capitalized, were fully depreciated, and subsequently replaced must also be capitalized.
Do Your Homework
Be sure to do your homework whenever you spend money on repairs or improvements
to your property. With adequate planning and documentation you can maximize
your deductible expenses. Be sure to review your deductions with your
tax preparer, who should be able to advise you what to do prior to the
expenditure, as well as how to best document the expenditure for your
records and tax returns.
PLEASE NOTE: Key Business Institute, Inc. does not offer tax advice and the above article is not to be considered tax advice. This article points out one of the many reasons all real estate investors should have a knowledgeable tax advisor on their team.
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