Repairs vs. Improvements: New IRS Rules
Owning a rental property can be a great investment that also has the potential to yield financial rewards.
Perhaps the most prominent is building an increasing amount of equity in real estate that one day you can sell, retire in, or use for other purposes. In addition, depending on the situation landlords often earn extra income and tax benefits from the arrangement. Of course owning rental property is not without challenges. There are many responsibilities toward both the property and the renters’ themselves. One of the most common things landlords think about is maintenance – repairs or improvements necessary to keep the property functional and increase market value. While owning is wonderful, it’s important to be IRS-compliant regarding tax rules, regulations and write-offs when it comes to repairs and improvements on your investment property.
For tax purposes it’s important to decide how to classify your expenses when it comes to making a repair or improvement. This is important because an expense classified as a repair can be deducted in a single year, while expenses classified as improvements have to depreciate over as many as 27.5 years!
As an example, if you classify a $1,000 expense as a repair, you get to deduct $1,000 for that tax year. If you classify it as an improvement, you'll likely have to depreciate it over 27.5 years and you'll get only a $35 deduction for that tax year. That's a big difference.
Unfortunately, telling the difference between a repair and an improvement can be difficult and confusing for many property owners. Due to these challenging situations, the IRS recently released new guidance to help determine what activities should be classified as a repair or improvement. To help clients, prospects and other understand the topic more closely, Hanson & Company has provided a brief summary below.
Improvements as defined under IRS Rules:
Under the new IRS regulations, property is improved whenever it undergoes a:
- Adaptation, or
Use the acronym “B A R = Improvement = Depreciate” to help you remember.
Example: If the need for the expense was caused by a particular event– say 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.
An expenditure is for a betterment if it:
- Improves a “material condition or defect” in the property that existed before it was acquired or when it was built. It makes no difference whether or not you were aware of the defect when you acquired the unit of property (UOP).
- Results in a “material addition” to the property. As an example, the addition physically enlarges, expands, or extends the property.
- Results in a “material increase” in the property's capacity, productivity, strength, or quality.
An expenditure is for a restoration if it:
- Returns a property that has fallen into disrepair to its normal and efficient operating condition.
- Rebuilds the property to a like-new condition after the end of its economic useful life.
- 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
- Repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.
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.
Have you recently completed repairs or maintenance on your rental property this year? Unsure how to classify these activities on your 2014 tax return? Contact Hanson & Company – we want to help! For additional information on repairs vs. improvements and their tax implications or for help filing your 2014 state and federal income tax returns, please contact us at (303) 388-1010 or click here for email.