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The Difference Between Repairs And Improvements On Your Taxes

September 30, 2022

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What Is The Difference Between Repairs And Improvements?

Maintenance is one of your largest expense categories as a landlord. Fortunately, most of your upkeep costs are tax deductible. 

Just like operating expenses, repairs and improvements are common expenses acknowledged by the tax code. 

However, they’re classified differently on your tax return.  

It’s essential to understand how to deduct these expenses correctly, so that you save as much money as possible—and don’t end up in hot water with the IRS. 

In this article, we’re going to look at how to classify and deduct repairs and improvements accurately. 

What’s the Difference Between Repairs and Improvements? 

A repair is any regular upkeep on your property that’s ordinary, necessary, current, rental-related, and reasonable. When you repair something, you’re fixing something broken, restoring something to its original state, or returning an appliance to its general, usable condition. Examples of repairs are patching a hole in the ceiling, fixing a broken faucet, or changing HVAC filters. 

Improvements greatly enhance the value of the property. These aren’t fixes. They lead to a better result than what came before. If you add new components, renovate something, adapt your property to a new purpose, or significantly prolong the life of the property, then that’s considered an improvement. Examples of improvements include replacing an entire HVAC system, installing a new shower, or adding a pool.   

It’s essential to understand the B.A.R. Rule when it comes to improvements. To be considered an improvement in the eyes of the IRS, it must meet one of three criteria: 

  1. A betterment enhances property value. This happens when you correct a defect that was there before you took over the property, materially expand the property, or improve the property’s productivity, strength, or capacity. Installing new carpet flooring is an example.  
  1. An adaptation means you switch the property to a new use. The new use has to differ from the “intended ordinary use” of the property. For example, if you change a garage into a room for rent, that is an adaptation.  
  1. A restoration dramatically extends the life of the property. When you return something to almost-new condition, replace a major component, or return items in disrepair to ordinary working condition, that is considered a restoration. An example is fixing a severely leaky kitchen sink. 

The IRS views repairs and improvements differently when it comes to your taxes. Almost every repair is an operating expense, and most improvements aren’t.  

Because most repairs are operating expenses, they’re deductible in the year incurred. This means you can subtract repair expenses from your taxable income and pay less overall tax on your properties. 

Improvements, though, must be depreciated over time. The reason is that they’re expected to go on longer than a year as capital assets and enhance the value of your property. 

As you can see, repairs are more advantageous for tax purposes because same-year deductions are usually much better than depreciated deductions. And, if you sell your property, the repairs you fully deducted don’t come back (e.g., they’re still never taxed). Depreciated deductions, on the other hand, return once you sell the property, so you’ll eventually have to pay taxes on those improvements. 

Safe Harbors 

The IRS issued an extensive list of repair protocols in 2014. These protocols provided “safe harbors” that allowed landlords to deduct almost all expenses regardless of repair or improvement classification. These are optional for you, but they’re in place to make your life easier and save you money long-term. 

You only need to meet one safe harbor to qualify your expenses. Let’s look at the three safe harbors and the criteria to meet each one: 

Safe Harbor for Small Taxpayers (SHST) 

Under the SHST, smaller landlords can deduct all annual maintenance expenses, including repairs, improvements, and other costs as operating expenses on Schedule E. You must meet size, expense, and income limits, though: 

  • For size, your building cannot exceed $1 million in value. 
  • For expense, the total mustn’t surpass the lesser of $10,000 or two percent of the property’s unadjusted basis. 
  • For income, you can’t earn more than $10 million over the past three tax years. 

Routine Maintenance Safe Harbor  

This one is available to any landlord. It allows routine maintenance to be deducted in one year as an operating expense. “Routine” covers maintenance that is typical work done to maintain a building or building system, such as cleaning, inspecting, and replacing parts. There are two key rules for this safe harbor: 

  • The Ten-Year Rule means that you must expect to perform maintenance multiple times in the ten years after the building is in service. 
  • Secondly, there cannot be betterments or restoration. This means your maintenance efforts cannot enhance the value of the building beyond what is expected of ordinary working condition. 

There are a few more things to note if you use this safe harbor. First, you can’t use it for maintenance immediately after purchasing a property because that counts for the previous owner. Secondly, this safe harbor counts against the $10,000 expense limit related to the SHST. Finally, if you utilize this safe harbor as a method of accounting, you have to use it every year. 

De Minimis Safe Harbor 

This safe harbor is for deducting low-cost items. As long as the item is less than $2,500 each year, it doesn’t matter whether it’s a repair or an improvement. You can claim it by filing an election with your return and using the relevant accounting policy. 

Like the Routine Maintenance Safe Harbor, these deducted expenses also count against the SHST expense cap. 

Tips to Differentiate Repairs and Improvements 

Not every expense clearly goes into one category or the other. For those, it’s important to know how to determine what kind of expense you’re dealing with. 

If expenses don’t automatically go under a safe harbor, you can use two simple steps to determine how to classify them: 

Step 1: Identify the Unit of Property (UOP)  

A UOP is a specific type of item that can be repaired or improved. The IRS defines UOPs as the building structure, HVAC systems, plumbing, electrical systems, escalators, elevators, fire/alarm systems, security systems, and gas distribution systems. 

The expense’s impact on the UOP will help you determine how to categorize it. When you have something directly related to the defined UOPs, it is most likely to be a repair. For instance, fixing rooftop air conditioning units would relate directly to the HVAC system. Thus, that would qualify as a repair. 

Step 2: Determine whether the UOP was repaired or improved 

Use the B.A.R. rule here. And remember to use the UOP, not the whole property, as the basis for your determination. 

Once you’ve listed repairs and improvements distinctly on Schedule E, you can begin to figure out the relevant deduction or depreciation, respectively.  

Pointers for Classifying Expenses as Repairs 

As we’ve learned, you want as many expenses to be considered repairs as possible. It’s more beneficial. Here are six tips to make that happen: 

  1. Track your repairs and improvements separately. It’s much easier to show that an expense was a repair if you always classify it as a repair. This will also help you when the time comes to complete Schedule E. 
  1. Track all tenant complaints. If you can show something was broken, the IRS will probably consider the expense of fixing it as a repair. 
  1. Always get separate invoices. Even if you have one contractor do a series of jobs, split up each bill individually. This is also important because you want contractors to describe everything they possibly can as a repair. 
  1. Conduct preventative maintenance. Routine maintenance of equipment and appliances is always deductible. 
  1. Delay big projects when you can. Repairs made prior to your property being ready for renting are not deductible. Thus, it’s a no-brainer to delay these whenever possible. 
  1. Consider adopting property management software. It can be extremely overwhelming to track and organize everything tax-related.  

Conclusion 

Repairs and improvements are two key elements when it comes to landlord taxes. Understanding how the tax code regards each can save you money.  

The key is learning to differentiate between the two and using the safe harbors to your advantage.  

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