When is a “repair” a repair and when is it a capital improvement for federal and state income

tax purposes? This is a question that every small property owner contends with at tax time.

In theory, at least, the concept is simple. If you have an electrical problem in a common area of your rental building fixed, that is clearly a repair (and 100% expensible in that year). In contrast, the brand new roof you installed on your building at a cost of $20,000 is a capital improvement, and must be depreciated. 

A Big Tax Advantage

The obvious advantage of classifying an expense as a repair is that 100% of its cost goes to reduce your taxable income in that calendar year. In the case of the roof, it would be to your benefit to expense the entire $20,000 as a repair than to depreciate it over 15 years. If you’re in the 30% tax bracket, this $20,000 sheltering of income translates to a tax savings of $5,994 in that year. But with roofs and other depreciated business assets, many listed in the table above, there’s the 15-year depreciation bonus: you can depreciate half the cost of the new roof the first year and the balance over the following 15 years. 

Repair Versus Improvement Is Not Always Clear Cut

The IRS website, www.irs.gov, provides some basic, but at times confusing, guidelines on the issue of repair versus improvement. For example:

“If you improve depreciable property, you must treat the improvement as separate depreciable property. Improvement means an addition to or partial replacement of property that is a betterment to the property, restores the property, or adapts it to a new or different use.

  • You generally deduct the cost of repairing business property in the same way as any other business expense. However, if the cost is for a betterment to the property, to restore it, or to adapt it to a new or different use, you must treat it as an improvement, and depreciate it.
  • Although the high cost of the work performed may also be considered in determining whether an expenditure is capital in nature, cost alone is not the key factor.” An example, cited by the IRS, illustrates the difficulty in determining how to classify some expenses: “You repair a small section of the roof of a rental house. You deduct the cost of the repair as a rental expense. However, if you remove the old roof and replace it with a new one, the expense is an improvement because it restores the property. You must depreciate the cost of the new roof.” But how much of a roof must be repaired before it becomes a replacement (i.e., an improvement)? And if another roof is put on top of the existing roof, isn’t that a repair, because it extends the life of the roof and does not involve removal of the old one? Questions like these – the “gray areas” – come up all the time, and demonstrate that sometimes making a determination is a matter of interpretation. 

When in Doubt, Consult a Tax Expert

The more aggressive your approach to taxation issues in the gray areas, the more red flags IRS auditors will see, and the more likely you are to be audited, with possible reclassification of expenses, back taxes, and penalties.

If you do take a more aggressive approach and are audited, be prepared to defend your position with documentation and support from IRS codes or regulations, memos, or tax court decisions. If you have any doubts about where to place an expense, especially a large one, seek the opinion of a CPA or tax attorney.

Examples of  Capital Improvements

According to the IRS, the addition or upgrade of all items listed here must be capitalized and depreciated over multiple years:

Heating & AC

  • Heating system
  • Central AC
  • Furnace
  • Ductwork
  • Central humidifier
  • Filtration System

Lawn and Grounds

  • Landscaping
  • Driveway
  • Walkway
  • Fence
  • Retaining Wall
  • Sprinkler System
    Swimming Pool

Additions

  • Bedroom/bathrooms
  • Deck
  • Garage
  • Porch/Patio
  • Plumbing
  • Septic System
  • Water Heater
  • Soft Water System
  • Filtration System

Interior Improvements

  • Built-in Appliances
  • Kitchen modernization
  • Flooring
  • Wall to wall carpeting

Miscellaneous

  • Storm windows, doors
  • New roof
  • Central Vacuum
  • Wiring upgrades
  • Satellite Dish
  • Security System
  • Attic, wall, floor insulation

Reprinted with permission of the Small Property Owners of San Francisco Institute (SPOSFI) News.  For more information on becoming a member of SPOSFI or to send a tax-deductible donation, please visit their website at www.smallprop.org or call (415) 647-2419.