Q: Tax Playa, I own some rental properties and had a lot of work done to fix them up. Can I deduct all of those costs the first year?
Maury, Fairfax VA
A: The tax code makes a distinction between a "repair" (something to keep a business asset in good working order) and an "improvement" (something that adds value to property). This distinction makes all the difference in the world--a repair is immediately-deductible, whereas an improvement has to be slowly depreciated over as long as 40 years...
For more information on this, see IRS Publication 527, Residential Rental Property.
This conversation is largely-limited to the area of rental property. Personal expenditures to service a residence are never deductible, though they may add to basis and reduce capital gains later.
Let's start with the definitions of terms:
Repair: deductible; keeps property in good operating condition; does not materially add to the value of property; does not prolong property's useful life
Improvement: capitalized (depreciated); adds to the value of property, prolongs its useful life, or adapts it to new uses; an extensive series of remodeling repairs is considered an improvement
As you can see, this makes a fairly fine and legalistic distinction. Some things are obvious. Installing a brand new island in a kitchen is obviously an improvement. Putting some replacement wallpaper up is obviously a repair.
The IRS gives some examples of things that may fall into the gray area, but are actually improvements:
- Additions, like new rooms and decks
- Major changes to lawn and grounds, like roads and landscaping
- Miscellaneous major upgrades, like rewiring or a new roof
- Heating and air conditioning units
- Plumbing systems
- Interior improvements like appliances
The difference between an improvement and a repair can be a costly one. A repair is deductible the first year. An improvement must be slowly deducted (depreciated) and eventually recaptured as a capital gain. The depreciable lives involved usually are:
- 7 years (10 in AMT): new appliances installed
- 15 years (20 in AMT): major land improvements
- 27.5 years (40 in AMT): residential rental property direct improvements
- 39 years (40 in AMT): non-residential rental property direct improvements
Let's take an extreme example to illustrate. Suppose a taxpayer is in the 28% federal tax bracket, and is in AMT. He spends $10,000 on a rental property expenditure. If this is a repair, his taxes are reduced by $2800 the first year. If it is an improvement, his taxes would be reduced by $70 per year for forty years (no adjustment for inflation).
Obviously, the bias is toward taxpayers claiming that an expenditure is a repair rather than an improvement. In an honest-to-God judgment call, it really comes down to the comfort level of the taxpayer. If the taxpayer is prepared to potentially defend the expenditure under IRS scrutiny, and if the tax professional legitimately-believes this is a gray area, then I believe it is the duty of the tax professional to represent the best interest of the client and take the repair deduction.
This is not to say that preparers should lead their clients (nor should taxpayers lead themselves) down the primrose path of repairs. If it seems like a stretch to call something a repair under IRS rules, then it is probably an improvement.