Besides picking out the perfect addition or decoration for your rental property, you also need to think about whether the expense is considered a repair or maintenance type cost or capital improvement expenditure for tax purposes. This is very important because it significantly impacts your tax deductions if you are not in the trade or business of renting properties.
Let’s say you classified a $2,000 expense as a repair and maintenance expense, you would get to deduct the whole $2,000 during the year the expense was incurred. On the other hand, if you classified it as a capital improvement, depending on the type of improvement, you may only get to deduct $133 on the first year since you need to spread the cost evenly over 15 years.
So let’s figure out when you get to deduct the full expense and when you must capitalize and depreciate it.
Under the IRS regulations, capital improvements have the following characteristics:
- They add value to the property.
- They prolong the useful life of the property.
- They adapt the property into a new or different use. A use is “new or different” when it is not the same as what the property was intended to be used for when it was first placed into service.
- They restore the property into a “like new” condition.
- They increase the capacity, productivity, and efficiency of the property.
- They fix a material defect or flaw of the property that existed before you acquired the property.
Examples include adding a recreation room, a new fence or roof, installing a water heater or kitchen cabinets, or paving a driveway. Generally, these expenditures improve the property, hence adding onto the cost of the asset.
Repair and Maintenance
On the other hand, repair and maintenance expenses have the following characteristics:
- They keep the property in normal operating condition.
- They conserve the property through routine maintenance.
- They do not materially add value to the property.
Examples are painting, fixing leaks, ordinary repairs, and replacing broken windows or other parts of the property. Generally, you would expect to perform repair & maintenance activities regularly over the useful life of the asset.
A Company Vehicle
Aside from real estate properties, let’s look at an example about a company vehicle. Repairs & maintenance expense would include replacing the car battery or a tire when they get worn out. These repairs may normally occur every 3-4 years.
On the other hand, the vehicle may start to have bigger issues such as engine or transmission problems after a number of years. And let’s assume the company does not have enough cash at the time to replace it with a new vehicle, the owner may decide to replace the engine or transmission so the vehicle can continue to be used.
In this case, the cost to replace the engine needs to be capitalized because it prolongs the useful life of the car and makes it more productive and efficient.
What Does It Mean For You?
A capital improvement will add value to your property. It may also extend the time of the depreciation deduction for several years.
On the other side, the entire cost of a repair and maintenance expense, such as fixing broken windows, can be immediately deducted on your taxes, leaving more money in your pocket by increasing your after-tax income.
There is a loophole used by some landlords and rental property owners, which consists of placing a tenant in the property first and then performing ‘repairs’ on the unit. The landlord may then classify more extensive maintenance as repair and maintenance expenses since they are necessary to keep the tenant satisfied.
You should first advise with your CPA to understand the correct classifications for your improvements and repairs expenses.
I hope this gives you some help and further insights into the differences between capital improvement and repair & maintenance expense. If you have any questions please comment below, or contact us.
Cheuk Wong is a staff accountant at Milam, Knecht & Warner, LLP. She graduated from USC with a double bachelor’s degree in Accounting and Business Administration – Finance. outside of work, Cheuk enjoys playing basketball, piano, reading a good book, and watching funny cat videos on the internet.