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As a real estate investor owning rental property, you will eventually incur expenses regarding the upkeep of the building. You will have to do work varying from repainting rooms in-between tenants, to replacing floor tiles, to even putting on a new roof. But to what extent are home improvements tax deductible?
It depends on whether the "improvement" is classified as a repair or capital expenditure. You can deduct a repair expense against the rental income for that year. If the expenses are classified as a capital expenditures, the cost is depreciated over 27.5 years. This difference in home tax deductions is huge.
Understanding the difference between an improvement and repair is critical. We use this information during the decision-making process to identify tax savings opportunities.
Imagine you had to spend $1,000 on a repair to an existing plumbing system. You can likely deduct the full $1,000 cost against your rental income. If you decided to replace the entire plumbing system for $2,000, the story is a little different. The latter is likely considered a capital improvement, you will only be able to deduct $73 (2000/27.5) in any given year. That’s a difference of over $900. That brings us back to our original question: when are home improvements tax deductible?
Improvements that Qualify as Repairs
Reg. § 1.162-4 provides that the cost of incidental repairs may be deducted. Incidental repairs are incurred to keep the property operating normally. They neither materially add to the value of the property nor significantly prolong its life. Simply put, repairs are simple fixes. The key is that repairs cannot add significant value to the property or extend its life.
Related: The Ultimate Guide to IRS Schedule E for Real Estate Investors
Examples of repairs:
- Repairing only the damaged shingles on a roof
- Fixing lighting fixtures
- Repairing smoke detectors
- Replacing only the cracked floor tiles
- Fixing HVAC units
- Repainting the unit
None of these repairs add significant value to the property. Undergoing these repairs simply maintain the current function of the property.
Improvements that are Capital Expenditures
Reg. § 1.263(a)-1(b) provides that capital expenditures do one of two things. First, they add to the value or substantially prolong the useful life of the property. Second, they adapt property to a new or different use. While a repair simply keeps the property in operating condition, an improvement adds significant value and prolongs the property's life.. The costs are then depreciated over 27.5 years, just like the original structure.
Related: How to Calculate Rental Property Depreciation Expense
Examples of improvements:
- Replacing the roof
- Replacing the plumbing for the property
- Replacing the floors
- Replacing HVAC unit
- Installing a new carpet
- Replacing all windows
- Renovations
Improvements that are capital expenditures usually completely replace a component of your property. With a replacement, you are creating new value that then adds to the property and likely extends the life of the property.
When Are Home Improvements Tax Deductible?
To help with the deductibility of the costs to repair your property, focus on patching and mending. Avoid completely replacing a component. If the roof is leaking, repair the shingles where the leak is taking place. Try not to replace the entire roof. It sounds simple, but many investors prefer to replace it to avoid future hassles. However, they fail to realize a $500 repair that is immediately deductible is advantageous. Especially when the alternative is recovering costs over 27.5 years.
For instance, say we have a faulty HVAC unit. There are the two options: replace or repair. The repair will cost $300 and will only extend the life another two years. The replacement will cost $3500 and last 20 years. So lets break it down. In order to match the lifespan of the replacement HVAC, the repair would have to take place 10 times. The options then show the repair will have $3000 in cost over the 20 years, but each expense is completely deductible in the year in which they occur. Whereas, the replacement will be a $3500 one time fee, and only $127 is deductible per year (3500/27.5).
Related: The Real Estate CPA Podcast, Episode #5 - Rental Property Improvements and Taxes
From a tax perspective, continuously repairing the HVAC will save us more money over time in terms of tax savings. That's why we recommend that you "patch and mend" rather than go for a full blown replacement.
Replacing the flooring is another great example. Say we have bad flooring throughout a unit that needs to be repaired or replaced. We can "patch and mend" and be able to deduct the cost of the repair in the current year. But if we replace the flooring throughout the unit, we're stuck with a capital asset that must be depreciated.
There are other factors of home tax deductions to consider, such as the Final IRS Tangible Property Regulations and the safe harbors that come along with them. But that will be for another post.
Left feeling like we didn't fully answer our question "are home improvements tax deductible?" Answering this question involves a deep dive into the facts and circumstances of your situation. We always aim to provide free guidance via our writing, but if you are left wanting more, feel free to give us a call.
The biggest piece of advice I can give you, without trying to sound self serving, is to seek a professional's opinion. Even when you think you know the rules inside and out, you'd be surprised to learn about new twists and turns. Repairs vs Improvements can be quite a grey area. Don't get stuck with your pants down when the IRS comes knocking.