There’s a world of tax difference between repairs to real estate property and capital improvements. And it’s not just semantics. The characterization could result in an increase or decrease of thousands of dollars on your tax return.
Basic premise: Repairs are currently deductible in full and can be used to offset the tax from rental income. On the other hand, improvements must be written off over a period of years. It takes 27.5 years to write off improvements for residential rental real estate, 39 years for non-residential property.
Usually, you’ll prefer to characterize work as repairs in order to benefit from faster write-offs. But you can’t simply call the work a “repair” for your own tax convenience. Instead, you must follow the tax law definitions.
Repairs generally do not materially add to the value of the property or prolong its useful life. They merely keep the property in operating condition. Conversely, improvements extend the useful life of the property, increase its value or adapt it for a different use. As an example, fixing a broken windowpane is clearly a repair, but installing a new roof is generally treated as an improvement.
Note: Repairs may not be currently deductible if the work is included in a “general plan of rehabilitation.” Courts have held that expenses incurred, as part of a general plan of rehabilitation, must be capitalized even if they otherwise would have been deductible as ordinary and necessary business expenses.
Recent tax law change benefits taxpayers
A recent tax law change allows the depreciable lives and methods for capitalized improvements to be revisited for 2018 and 2019. These improvements, originally capitalized with a life of 27.5 years (for residential property) or 39 years (for non-residential property) may be able to be reduced to a 15-year life and then may be able to be written off in part or in full in the year of capitalization. Check with your tax advisor if you have capitalized improvements in either 2018 or 2019.
One case example
A taxpayer claimed deductions or repairs on his 33 rental real estate properties. He asserted that, beginning five years before, he had planned to capitalize all repair expenses more than $5,000 and to increase that threshold
5 percent each year. The IRS maintained that 78 percent of the amount claimed for these repairs could be immediately deductible, but the remaining 22 percent should be capitalized.
The taxpayer agreed with the IRS that $30,107 of the claimed $134,863 repair expenses — the 22 percent established by the IRS — constituted capital expenditures. But then the taxpayer argued before the U.S. Tax Court that he should be allowed to deduct these remaining expenses to make up for the amounts he was not permitted to deduct in earlier years.
The taxpayer did not substantiate this claim with any evidence, and it was unclear how events transpiring earlier affect the year in issue. Result: He wasn’t entitled to deduct 22 percent of the repair expenses initially claimed. (Donald Wm. Trask, TC Memo 2010-78).
Another relevant tax court case
After a tenant complained about a leaky roof on a rental house in Long Beach, California, the landlord paid $8,000 to have the roof removed and resurfaced and deducted the cost. (No structural changes were made.) The IRS argued it was a capital improvement.
According to court documents, “moisture began seeping through the walls into the main bedroom of the house” and the landlord stated that unless the roof was repaired, the house could not continue to be rented.
The Tax Court noted that the landlord’s only purpose in having the work done was to prevent leakage and keep the rental property in operating condition, “not to prolong the life of the property, increase its value or make it adaptable to another use.” Therefore, the Tax Court determined that the cost was a currently deductible repair and not an improvement. (Campbell, TC Sum Op. 2002-117).
Practical advice: It is recommended that you separate repair work from capital improvements on invoices if a current deduction is desired. If possible, you might space out the work over time. For instance, you could have the necessary repairs completed first and then wait several weeks or months to begin improvements. Your tax advisor can provide guidelines for arranging the work.