Are the repairs at your rental property an Expense or a Capital Improvement?
Making repairs to your rental property can be expensive, but at what point do those repairs count as fixed assets (or capital improvements) instead of expenses? Why does it matter if you record a repair as an expense or an improvement? Although it’s true that the cost of the repair will be the same whether you book it as an expense or a capital improvement, when it’s time to file your taxes, how that cost is recorded will determine how much of the repair you can deduct per year. Let’s break it down by category.
Rental Property Expenses
Expenses are property-related costs necessary for managing and maintaining your business. Unlike fixed assets, you deduct these costs in one year. The IRS allows for the deduction of both ordinary and necessary expenses.
Ordinary and Necessary Expenses
You can deduct certain costs associated with keeping your rental unit in good operating condition. Common, generally accepted expenditures for a specific trade or business are “ordinary expenses.” Necessary expenses are those deemed “appropriate” by the IRS. Rental property owners often deduct the following expenses:
Interest
Your mortgage company sends you IRS Form 1098 so you know how much interest you’ve paid on the mortgage for the year. That interest is deductible on your Schedule E.
Taxes
Depending on your level of participation in the investment property, you may be able to deduct the full amount of property, state, and local taxes. Be sure to review this option with your tax preparer.
Advertising
When you place an ad once your property is available for rent, that is deductible.
Maintenance
REI Hub’s most-used expense category is maintenance. Think of maintenance as small repairs that keep your property in good condition. Repairs include replacing a broken outlet cover, fixing a leaky sink faucet, or changing a lock. These aren’t adding value to your property; they’re maintaining the current value.
Utilities
Utilities are typically tax deductible for rental properties, even if they aren’t occupied for the full year.
Insurance
Your rental property should have insurance. Whether you have flood, liability, vandalism, dwelling insurance policies or more, your insurance expenditures are deductible.
Mileage
If you travel to collect rent payments, costs associated with those trips are deductible. There are limitations on how to handle mileage related to property maintenance, so be sure to review our article on mileage deductions.
Depreciation
Depreciation is the yearly deduction associated with fixed assets over the useful life of the asset. If you have to replace the roof on your investment property, you’ll deduct a portion of the expenditure each year over the lifetime of the new roof.
Legal fees
If you have a lawyer help you draft leases or other documents related to your real estate investment business, the fees that your attorney charges you are deductible.
Accounting or bookkeeping fees
If you use accounting software like REI Hub or hire a tax preparer to help you file your annual tax return, you can deduct those costs.
REI Hub makes it easy to record expenses. Check out our Getting Started and Overview guide to learn more!
Rental Property Fixed Assets and Capital Improvements
Repair and maintenance expenses are centered around maintaining the value of your property. What happens when you have an expenditure that adds value to your investment property?
Improvements, or fixed assets, add value or extend the useful life of your rental property and are depreciated over a set period; the total cost of the improvement can’t be deducted all at once according to IRS guidelines. Instead, you recover the cost through depreciation. When you pay for the improvement, only a percentage of the cost is deductible that year.
For an expenditure to count as a fixed asset, it must qualify as either a betterment, restoration, or adaptation.
Betterment
When an improvement is a betterment, it falls into one of three categories.
It corrects an issue or defect in your rental property. The defect either occurred during construction of the property or came into existence before you purchased the property.
For example, the rental property you purchased had a bad roof. The costs to install a new roof are an improvement because they correct a material condition created before your purchase.
It creates a material addition. This could be an expansion, extension, or addition of a serious component, allowing for an increase in the property’s capacity.
If you added on a primary suite to your rental unit, that counts as an expansion. If you had to redo the kitchen, it’s a serious component.
It results in a material increase in “productivity, efficiency, strength, quality, or output” of the property.
When you replace your rental property’s original windows with new, energy-efficient windows, that results in a material increase in efficiency.
Restoration
A property improvement must meet one of these criteria to qualify as a restoration.
It returns a property fallen into disrepair back to its normal, efficient operating condition.
When the property’s plumbing system fails, replacing it counts as a capital improvement.
It reconstructs the property, making it like new after the end of its economic useful life.
Your rental property’s detached garage deteriorated until it was no longer fit to rent out. You repair it, making it operational again, so that counts as a restoration.
It replaces a major element or structural component of the property.
For example, your property had foundation issues this year, and you had to replace structural support beams. The foundation repairs and new support beams are major structural elements.
It replaces a property component that the owner took a loss on, or the repair fixes property damage that the owner has taken a basis adjustment for a casualty loss.
If your rental property suffered from tornado damage and you had to make substantial repairs, they count as a restoration.
Note that if the cost of restoring the property is greater than the adjusted basis before the loss, the amount you may capitalize may be limited. Please consult with your tax preparer for these cases.
Adaptation
When the function of a property is converted to a new use not consistent with its ordinary use when it was first placed in service, you’ve adapted the property.
You own a barn and decide not to use it for agricultural purposes anymore. Instead, you pay to convert it to an Airbnb. You’ve adapted the property, and the costs count as capital improvements.
If you convert your above-garage storage area into a loft apartment, you’ve adapted its use. The associated costs are capital expenses.
If your expenditures meet the criteria for betterment, restoration, or adaptation, capitalize them! To learn more about how to track fixed assets and their depreciation in REI Hub, check out our related articles:
The De Minimis Safe Harbor Rule
There is an exception to the guidelines for recording fixed assets. With the IRS de minimis safe harbor election, you may deduct the cost of some tangible property, such as assets that would usually be depreciated. Generally, expenses reduce your income by a larger amount than depreciation does, so this election has the potential to either lower your tax bill or increase your refund.
To take the election, you must meet the following criteria:
You have a consistent bookkeeping process for recording expenses and assets.
You record the items in question as expenses on your books.
The cost of each item is shown on its receipt as $2,500 or less.
If you have an applicable financial statement for your business, the possible deduction amount may increase to $5,000. Check with your tax preparer to see if you qualify.
When you begin to record a fixed asset in REI Hub, we’ll remind you about the de minimis safe harbor election option. If you decide to take this election, you’ll need to include a statement with your tax return for the year in question. The IRS requires specific wording and references for the statement. You can find more details about the requirements in IRS Publication 535.
Expenses and Fixed Assets Quiz
Now that we’ve examined capital improvements and expenses, let’s take a short quiz to see which repairs fall into which category.
Situation 1: The AC unit in your rental property isn’t working. Your service technician says you need to replace the entire system. Is this an expense or a fixed asset?
Situation 2: Your rental property lost shingles during a bad storm. You’ll have to hire a roofing company to replace about 15% of the shingles. Will that be a capital improvement or an expense?
Situation 3: You replace the showerhead, faucets, and hardware in one bathroom at your rental property. Is that a capital improvement or an expense?
A1: The AC system is a major component of your rental property, so replacing it counts as a restoration; this is a fixed asset.
A2: This roof repair is small enough to count as an expense. If the entire roof had to be replaced, then it would count as a capital improvement.
A3: The upgrade fixtures and hardware are an expense. If you had remodeled the entire bathroom or upgraded the whole plumbing system, then it would be a capital improvement.
Takeaways
Rental properties have many costs associated with them, and recording those costs appropriately has significant tax implications. Expenses are deducted on your tax return in one year, but fixed assets are depreciated over several years. When you record your business costs, remember to ask yourself if the cost is a betterment, restoration, or adaptation; if so, add it to your books as a capital improvement. If the cost doesn’t meet any of the IRS’ three criteria for fixed assets, record it as an expense. Your CPA or tax preparer can also help you decide if you aren’t sure when an expense becomes an asset.
