Repairing versus improving a rental property considerations go beyond initial cost considerations; it also can reduce or increase your tax burden. The Internal Revenue Service (IRS) offers guidelines to determine whether work done to real estate rental property is considered a repair or an improvement.
Repairs
Repairs are defined as something that keeps property in working condition. Calling Handyman Fred out to fix the abovementioned dishwasher is considered a repair to the IRS. Repairs are a business expense and are fully deductable in the tax year the repair was made. Handyman Fred’s $100 charge for labor is $100 off your tax burden.
Improvements
Improvements are generally defined as something that increases the overall value of the property. Examples include:
• replacement
• expansion/new construction
• substantial rebuilding
• restoration
It is considered a capital outlay by the IRS, something done “having a useful life substantially beyond the tax year” according to Terry Myers, J.D. and Dee DeScherer, J.D. The IRS considers repairing the broken dishwasher to be a maintenance expense. But Ripping out the old dishwasher and installing a new appliance is considered an improvement. Handyman Fred charged you $500 for the dishwasher and installation. That $500 gets added to your tax basis in the property. Under MACRS rules, you normally depreciate the dishwasher over 5 years. Over your next five tax years, you are able to take $100 off per year off of your taxable income. (Accelerated guidelines not applied in this scenario).
Which Option to Choose?
Are you going to repair or are you going to improve your property? First, reflect on how long you are going to own this property. If you’re planning to sell, consider the following questions:
• Will you own it long enough to depreciate the full value of the improvement?
• Will the new market value substantially increase your capital gains taxes?
• Will you roll the property over into a 1031 exchange to avoid paying the capital gains taxes?
If you are planning to keep the property,
• Will the repair hold up long enough to keep from being a headache to you and your tenant?
• Does not replacing the item cause additional problems? For example, will a broken dishwasher cause water damage to the subfloor, costing you even more in the long run?
• How does does the cost of repair or maintenance compare to the replacement/improvement cost?
Note: Keep meticulous records and receipts for all work done to your property, whether repair or improvements. Every dollar you spend in improving the property adds to your tax basis in the property, which can pay off handsomely later when you eventually sell it. Contract with a tax attorney or a Certified Public Accountant (CPA). Let the professionals do the work you hire them for: By hiring a professional you are better able to correctly categorize the work done to your property and therefore take advantage of all possible deductions and depreciations allowed you by law.