If you’re a property owner or landlord, understanding the difference between capital improvements vs. repairs and maintenance might feel a bit stressful come tax season.
And that’s before getting into the question of learning how to classify expenses.
You’ll probably ask yourself a few questions, including:
So, certain expenses are annually tax-deductible, while others aren’t? Or, some expenses lower my tax burden after the property is sold or refinanced, but others won’t? What does it all mean?!
While confusing at times, navigating expense classifications and tax implications is an essential skill you’ll need while sorting through your receipts and invoices. We understand how complicated these topics can feel, so we’re here to simplify them.
To help you make sense of every expense, we will:
Capital improvements are any alteration or addition that permanently raises a property’s value. Maintenance and repairs, on the other hand, are any type of work that brings a property back to its original state and helps retain its value.
How each expense is ultimately classified will decide whether it’s annually tax-deductible or instead increases the property’s cost basis and associated annual tax depreciation and lowers an owner’s future capital gains tax. We’ll explore each scenario further in the following sections.
Again, a capital improvement is any permanent upgrade, alteration, or addition that increases a property’s value or lifespan. Such costs are classified separately from routine maintenance and repairs that aren’t meant to increase property value.
Capital improvements are tax deductible as depreciation expenses yearly. Plus, they add to the property’s “cost basis,” or the original purchase price, plus any improvement costs incurred during ownership. If and when the owner decides to sell the property, they’ll be subject to a capital gains tax, which is determined by calculating the difference between the selling price and the owner’s cost basis and then taxed at the applicable capital gains tax rate.
Repairs and maintenance encompass all expenses incurred to keep a property functioning as intended. If a given expense isn’t meant to raise a property’s value but instead helps restore it to its previous condition, it falls under the umbrella of repairs and maintenance.
Unlike capital improvements, repairs and maintenance expenses are tax-deductible in the year you pay for them and can thus be written off on annual taxes. However, these expenses cannot increase the property’s cost basis and won’t lower the owner’s tax burden once the property is sold.
Not every repair or improvement to a given property is easy to classify. Some expenses may fall into a gray area, leaving property owners, managers, and landlords seeking clarification on whether their expenses qualify as improvements or repairs.
Let’s say a homeowner hires a handyperson to repair a hole in their property’s drywall. The worker then discovers that the insulation behind the drywall is outdated and moldy. As a result, the homeowner asks the handyperson to remove and replace all the insulation with a newer, more efficient type that will lower the property’s heating bills over the long run.
In this example, what started as a routine maintenance request to restore a property’s value (repairing a hole in the drywall) turned into a much larger capital improvement project that increased the property’s value (replacing the insulation).
While the owner may have originally planned on deducting the repair expenses from their annual taxes, the scope of the maintenance changed, and the money spent was no longer eligible to be written off as a standard expense on the owner’s annual tax returns. Instead, the homeowner will depreciate the expense over a period of time as defined in the IRS’ Modified Accelerated Cost Recovery System, or MACRS.
If ever in doubt about expenses incurred while putting work into your property, ask yourself the following:
Did the expense in question help retain the property’s value or raise it?
As we explained earlier, capital improvement expenses aren’t tax-deductible like typical repair expenses. They do, however, count towards a property’s cost basis and will lower an owner’s tax burden if and when they decide to sell.
And, while value-adding capital improvements aren’t directly tax-deductible, they (as part of the physical property) will depreciate and lose value over time, allowing owners to claim higher annual depreciation deductions on their taxes.
Unlike capital improvements, repairs and maintenance expenses are tax-deductible but cannot be added to the cost basis of a property. Since these routine repairs don’t increase the home’s value, they won’t lower the property owner’s tax burden if and when the owner decides to sell.
Additionally, repairs and maintenance are not considered depreciable expenses and cannot be treated as such.
For more information on depreciation in regards to taxes, refer to pages 16-20 on the IRS’s “Selling Your Home” document. Also worth noting, residential rental real estate is subject to special depreciation recapture rules as both residential and commercial rental property is generally classified as Section 1250 property.
Here are a few tips on how to maximize tax deductions through strategic property expense management come tax season:
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Check out some reviews and sign up today to see how TurboTenant can enhance your property management experience.
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