According to the IRS, a capital improvement is an improvement that adds to the value of a property, extends its useful life, or adjusts it to new uses.
Whenever you repair or replace something in a rental unit or building, you need to determine whether the expense is a repair or improvement for tax purposes. Why is this necessary? Because you can deduct the cost of a repair in a single year, you have to depreciate improvements over as many as 27.5 years.
For instance, if you classify a $10,000 roof payment as a repair, you get to deduct $10,000 this year. If you classify it as an improvement, you have to depreciate it over 27.5 years, and you’ll get only a $350 deduction this year. That’s a significant contrast.
Unfortunately, describing the difference between a repair and an improvement can be challenging. The IRS issued lengthy regulations explaining how to tell the difference between repairs and improvements to clarify issues.
What Is an Improvement Under IRS Rules?
Under the IRS regulations, the property is improved whenever it experiences a:
- Adaptation, or
Think of the acronym B A R = Improvement = Depreciate.
If a specific event caused the need for the expense—for instance, a storm—you must compare the property’s condition just before the event and just after the work was done to make your conclusion. On the other hand, if you’re repairing everyday wear and tear to property, you must compare its condition after the last time you repaired everyday wear and tear (whether upkeep 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.
What Are Betterments?
An expenditure is for betterment if it:
- Facilitates a “material condition or defect” in the property that existed before it was acquired or when it was produced—it makes no difference whether or not you were cognizant of the defect when you received the unit of property
- Results in a “material addition” to the property—for instance, physically broadens, grows, or extends it, or
- Results in a “material increase” in the property’s capacity, productivity, power, or quality.
What Are Restorations?
An expenditure is for a restoration if it:
- Returns a property that has plunged into disrepair to its “ordinarily efficient operating condition”
- Revamps the property to a like-new condition after the end of its useful economic life
- Replaces a significant part or important structural component of the property
- Replaces a piece of a property for which the owner has taken a loss, or
- Repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.
What Are Adaptations?
You must also depreciate the charges you spend to adjust the 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 initially placed it into service.
What Does the IRS Consider a Unit of Property (UOP)?
To resolve whether you’ve improved your company or rental property, you must specify what the property consists of. The IRS calls this the “unit of property” (UOP). How the UOP is determined is necessary. The bigger the UOP, the more likely will work done on a piece be a deductible repair rather than an improvement that must be depreciated.
For instance, consider the UOP for an apartment building is portrayed as the entire building structure as a whole. In that circumstance, you could plausibly argue that replacing the fire escapes is a repair since it doesn’t seem that substantial compared with the whole building. On the other hand, if the UOP consists of the fire protection system independently, replacing fire escapes would likely be an improvement.
The IRS regulations require that buildings be split into as many as nine different UOPs: the entire structure and up to eight separate building systems. An improvement to any of these UOPs must be depreciated.
UOP #1: The Entire Building
The entire building and its structural components are a single UOP. A building’s structural components include:
- Walls, partitions, floors, and ceilings, and any enduring coverings on them such as paneling or tiling
- Windows and doors
- All central air conditioning or heating system features
- Plumbing and plumbing fixtures, such as sinks and bathtubs
- Electric wiring and lighting fixtures
- Stairs, escalators, and elevators
- Sprinkler systems
- Fire escapes
- Other details relating to the operation or maintenance of the building, and
For instance, replacing a building’s roof improves the building’s UOP.
UOP #2-9: Building Systems
In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems must be depreciated:
- Heating, ventilation, and air conditioning (“HVAC”) systems: This includes motors, compressors, boilers, furnaces, chillers, pipes, ducts, and radiators.
- Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water, sanitary sewer collection gear, and site utility tools used to distribute water and waste.
- Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to circulate electricity.
- All escalators.
- All elevators.
Is a Capital Improvement Deductible?
Capital improvements on a property are capital in nature, not typically deductible, and their cost must be recovered through depreciation deductions spread out over the applicable recovery period.
What Is a Maintenance Repair?
According to the IRS, a maintenance repair is a repair that keeps your property in satisfactory operating condition. A maintenance repair does not materially add to the value of your property or substantially extend its life.
Should I Take a Maintenance Repair Expense Deduction Now or Take Capital Depreciation Deduction Over Time?
In most circumstances, the taxpayer will pay less tax by classifying expenditure as a repair and taking a current deduction, rather than by capitalizing the payment and recovering the cost by way of depreciation.
Over the years, taxpayers have taken an aggressive stance towards classifying most things like repairs. IRS agents have paid close attention to repair and maintenance deductions claimed on people’s tax returns.
How Could the IRS Handle Work That Go Either Way?
The IRS has embraced general guidelines to determine what transpires when work could go either way. They have noted that in determining whether an expenditure is a capital chargeable against operating income, one must bear in mind the purpose of the spending.
The following general checklist helps the taxpayer in making the determination:
- To repair is to restore to a sound state or to mend
- Capital replacement connotes a substitution
- A repair is an expenditure to keep the property in an ordinarily efficient operating condition
- Repairs do not add to the value of the property
- Repairs do not appreciably prolong property life
- Repairs merely keep the property in an operating condition over its probable useful life for the uses for which it was acquired
- Capital replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to different uses
Should I Contact a Lawyer Regarding the Work Put into a Property of Mine?
Making the above distinction can sometimes be tough, even for experienced judges and tax attorneys. For this reason, if you own property and are uncertain about how to distinguish work you have had done on a property, it is highly recommended to contact an adept tax attorney to avoid problems with the tax authorities.