• Landlord Taxes

Repairs vs. Improvements in Real Estate

December 20, 2024 7 min read

What Is The Difference Between Repairs vs. Improvements?

Maintenance is one of the largest expense categories for landlords. From regular upkeep to larger projects, keeping rental properties in top condition requires a significant investment of your revenue.

Fortunately, most of these costs are tax deductible. However, correctly categorizing and deducting maintenance expenses—whether they’re repairs or improvements—is crucial. Missteps could result in missed saving or IRS penalties for a property owner.

In this article, we’ll explore the differences between repairs and improvements, how they are treated on your tax return, and how to maximize your tax savings by handling these expenses correctly.

Repairs vs. Improvements: Overview

The IRS classifies repairs and improvements differently, and understanding the distinctions between capital improvements vs. repairs is essential for accurate deductions:

• Repairs: Repairs are regular upkeep activities necessary to maintain the property in its original, usable condition. These expenses must meet four criteria: ordinary/necessary, current, rental-related, and reasonable. Common examples include patching holes in ceilings, fixing broken faucets, or replacing HVAC filters.
• Improvements: Improvements significantly enhance the value or extend the useful life of a property or its structural components. These are not fixes but substantial projects that add new components, renovate extensively, or adapt the building or building systems to a new purpose. Examples of real property capital improvements include replacing an entire HVAC system, installing security systems, or constructing a pool.

Tax Treatment of Repairs and Improvements

The IRS treats repairs and improvements differently for tax purposes. Below is an explanation of the tax implications of each category.

• Repairs: These are considered operating expenses and are fully deductible in the year they are incurred. This means you can subtract the cost of repairs directly from your taxable income, resulting in near immediate tax savings.
• Improvements: These are treated as capital expenditures and must be depreciated over multiple years. While they do provide long-term value, the depreciation schedule spreads the tax benefit over time instead of providing immediate tax relief.

Why Classification Matters

Accurate classification can significantly impact your tax savings. Because repairs are fully deductible in the same year, they typically provide a more advantageous tax benefit compared to improvements. For example, a $2,000 repair will reduce your taxable income by $2,000 immediately, whereas a $2,000 improvement might only provide a $200 annual deduction over ten years. The immediate repair deduction will give you more income in the short term to re-invest in your rental business.

When you sell your property, tax deductions for repairs are permanent—they are not taxed again. However, depreciation deductions for improvements are recaptured during the sale process, meaning you pay taxes on them later.

Here are some tips to stay compliant with IRS rules and maximize your deductions:

1. Document Everything: Keep detailed records of all maintenance activities and expenses incurred, including receipts, invoices, and descriptions of the work.
2. Follow IRS Criteria: Use the IRS’s guidelines to determine whether an expense qualifies as a repair or an improvement on your annual taxes.
3. Consult a Tax Professional: For complex situations or significant projects, seek guidance from a tax expert to ensure correct classification.

By understanding the differences between capital improvements vs. repairs and maintenance as well as following proper procedures, you can save money and avoid costly mistakes. If you stay diligent and keep clear records, you’ll be well-positioned to maximize your tax benefits while staying in good standing with the IRS.

What Are Repairs?

Repairs are routine maintenance tasks that restore something to its original working condition without adding significant value to the property. These are considered operating expenses, which means they can be fully deducted in the year they occur.

Examples of Repairs

• Patching a hole in a wall
• Changing HVAC filters
• Replacing a few shingles on a roof

To deduct repairs, list them under the appropriate category on Schedule E Supplemental Income and Loss, which should be filed with your tax return. Because repairs are immediate deductions, they reduce your taxable income right away, leading to same-year savings.

It’s important to ensure that expenses you have classified as repairs don’t escalate into improvements. For instance, a project that starts as fixing a roof leak could turn into a full roof replacement, which would then qualify as an improvement rather than a repair.

What are Improvements?

Improvements, also called capital improvements, are larger-scale projects designed to significantly enhance the property. Unlike repairs, improvements add value, adapt the property to a new purpose, or restore it in a way that extends its life.

Examples of Improvements

• Replacing an entire HVAC system
• Renovating a kitchen
• Constructing a pool
• Converting a garage into a rental unit

While improvements enhance the property’s long-term value, they are less advantageous for taxes in the short term since their costs are spread out over many years rather than deducted all at once.

Classifying Improvements with the IRS B.A.R. Rule

To help classify expenses, the IRS uses the B.A.R. Rule, which defines improvements as any project that involves one of the following:

1. Betterment — Adds value to the property by correcting pre-existing defects, expanding the property, or increasing its productivity. Example: Installing new hardwood flooring.

2. Adaptation — Changes the property’s use to something new or different. Example: Converting a garage into a storage unit.

3. Restoration — Significantly extends the property’s life, replaces a major component, or returns a neglected property to like-new condition. Example: Replacing old parts in a neglected water heater.

If an expense meets any of these criteria, it must be classified as an improvement and depreciated accordingly.

Differentiating Repairs and Improvements

Not every expense clearly fits into one category or the other. For such cases, it’s crucial to know how to determine the type of expense you’re dealing with.

If an expense doesn’t automatically fall under a safe harbor rule, you can follow two straightforward steps to classify it:

Step 1: Identify the Unit of Property (UOP)

The Unit of Property (UOP) refers to a specific item that can be repaired or improved. According to the IRS, UOPs include the building structure, HVAC systems, plumbing, electrical systems, and gas distribution systems.

Stary by assessing the expense's impact on the UOP. If the expense directly relates to one of these defined UOPS, it is likely to qualify as a repair. For example, fixing a rooftop air conditioning unit pertains to the HVAC system and would typically be categorized as a repair.

Step 2: Determine Whether the UOP Was Repaired or Improved

Next use the B.A.R. rule (Betterment, Adaptation, or Restoration) to determine if the expense was a repair or an improvement. Focus on the UOP itself rather than the entire property.

• Betterment: Did the expense address a material defect or improve the UOP’s performance?
• Adaptation: Was the UOP modified for a new use?
• Restoration: Did the expense return the UOP to its original state after it deteriorated?

If you’re still unsure whether a project qualifies as a repair or capital improvement, consult a real estate tax professional.

The Bottom Line

For landlords, understanding the distinction between repairs and improvements is essential for optimizing tax benefits and maximizing long-term returns. The way the tax code classifies these expenses can significantly impact your rental property business, making it vital to approach property maintenance and upgrades with strategic planning.

Repairs and routine maintenance are not just immediate necessities—they are opportunities to extend the life of your property and maintain tenant satisfaction. These efforts can boost tenant retention and potentially lead to a higher return on investment (ROI). On the other hand, capital improvements, while enhancing the property’s value over time, must be carefully categorized to ensure compliance with depreciation rules.

By differentiating between repairs and improvements and keeping meticulous records, you can reduce your tax liability, reinvest savings into your properties, and ultimately grow your rental property portfolio.

Understanding and applying these principles isn’t just about savings on taxes—it's about setting yourself up for long-term success as a rental property investor.