June 6, 2021
Understand the Difference Between Repairs vs. Capital Improvements for a Rental Property
Understand the Difference Between Repairs vs. Capital Improvements for a Rental Property
Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you must depreciate improvements over as many as 27.5/39 years.
For example, if you classify a $10,000 roof expense as a repair, you get to deduct $10,000 this year. If you classify it as an improvement, you have to depreciate it over 27.5 years, and you'll get only a $350 deduction this year.
That's a big difference.
Unfortunately, telling the difference between a repair and an improvement can be difficult. In an attempt to clarify matters, the IRS issued lengthy regulations explaining how to tell the difference between repairs and improvements.
What Is an Improvement Under IRS Rules?
Under the IRS regulations, property is improved whenever it undergoes a:
- Betterment
- Adaptation, or
- Restoration.
Think of the acronym B A R = Improvement = Depreciate.
If the need for the expense was caused by a particular event—for example, a storm—you must compare the property's condition just before the event and just after the work was done to make your determination. On the other hand, if you're correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you've never had any work done on the property, use its condition when placed in service as your point of comparison.
Betterments
An expenditure is for a betterment if it:
- "Material condition or defect" in the property that existed before it was acquired or when it was produced—it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
- results in a "material addition" to the property—for example, physically enlarges, expands, or extends it, or
- results in a "material increase" in the property's capacity, productivity, strength, or quality.
Restorations
An expenditure is for a restoration if it:
- returns a property that has fallen into disrepair to its "ordinarily efficient operating condition".
- rebuilds the property to a like-new condition after the end of its economic useful life, or
- replaces a major component or substantial structural part of the property.
- replaces a component of a property for which the owner has taken a loss, or
- repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.
Adaptations
You must also depreciate amounts you spend to adapt property to a new or different use. A use is "new or different" if it is not consistent with your "intended ordinary use" of the property when you originally placed it into service.
Using Safe Harbors to Deduct Repairs and Improvements
As the above discussion shows, it can be difficult to determine whether an expense is for a repair or improvement. Fortunately, landlords may use three "safe harbor" rules to bypass the repair-improvement conundrum and currently deduct many expenses regardless of whether they should be classified as improvements or repairs under the IRS regulations. These are:
- the safe harbor for small taxpayers
- routine maintenance safe harbor, and
- de minimis safe harbor.
Safe Harbor for Small Taxpayers
The safe harbor for small taxpayers (SHST) allows landlords to currently deduct all annual expenses for repairs, maintenance, improvements, and other costs for a rental building. However, the SHST may only be used for rental buildings that cost $1 million or less. And the annual SHST deduction is limited to the lesser of $10,000 or 2% of the unadjusted basis of the building. This limit is determined on a building-by-building basis—for example, if you own three rental homes, you apply the limit to each home separately.
Routine Maintenance Safe Harbor
Expenses that qualify for the routine maintenance safe harbor are automatically deductible in a single year, even if they would otherwise qualify as improvements that ordinarily must be depreciated over several years. Routine maintenance consists of recurring work a building owner does to keep an entire building, or each system in a building, in ordinarily efficient operating condition. It includes:
- inspection, cleaning, and testing of the building structure and/or each building system, and
- replacement of damaged or worn parts with comparable and commercially available replacement parts.
Routine maintenance can be performed and deducted under the safe harbor any time during the property's useful life. However, building maintenance qualifies for the routine maintenance safe harbor only if, when you placed the building or building system into service, you reasonably expected to perform such maintenance more than once every ten years. Moreover, the safe harbor may not be used for expenses for betterments or restorations of buildings or other business property in a state of disrepair.
De Minimis Safe Harbor
Landlords may use the de minimis safe harbor to currently deduct any low-cost property items used in their rental business, regardless of whether or not the item would constitute a repair or an improvement under the regular repair regulations. The safe harbor can be used for personal property and for building components that come within the deduction ceiling. For example, it could be used for the cost to replace a building component like a garage door or bathroom sink. For most landlords, the maximum amount that can be deducted under this safe harbor is $2,500 per item, as shown on the invoice.
All expenses you deduct using the de minimis safe harbor must be counted toward the annual limit for using the safe harbor for small taxpayers (the lesser of 2% of the rental's cost or $10,000).
For the latest IRS rules on repairs and improvements, see the IRS online guide Tangible Property Regulations
Printable PDF