Use Repairs to Maximize Deductions

1. Introduction

The cost of repairs that you make to your rental property is deductible in the year paid. In contrast, improvements on the same property are capital in nature, and their cost must be recovered through depreciation deductions spread over the applicable recovery period.

In most cases, the taxpayer would pay less immediate taxes by classifying the expenditure as a repair and taking a current deduction, rather than by capitalizing the expense and recovering the cost by way of depreciation.

Given this fact, it is no wonder that most taxpayers take a very aggressive position classifying most, if not all, of their expenditures as repairs. Knowing this, it should be no surprise that IRS agents will pay close attention to repair and maintenance deductions claimed on your tax return.

This article will first review how the government goes about defining and differentiating between repairs and improvements; suggest strategies to help you maximize your ability to classify expenditures as repairs; and finally inform you how to maximize the deduction for those items that you are forced to capitalize.

2. Repairs vs. Improvements

The Internal Revenue Service, which gets the most in the day-to-day effort of reviewing tax returns, has defined the difference between repairs and improvements in Pub.527as follows:

“A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life.”

“An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses.”

Although these definitions are relatively simple, in practice there has been a great deal of difficulty in distinguishing between repairs and improvements. There is no official IRS checklist.

The Department of Treasury, which is responsible for setting up formal rules and regulations for enforcing tax law, distinguishes between repairs and improvements in Reg. Section 1.162-4 as follows:

“cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense... repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall be capitalized and depreciated”

The Tax Courts have had to deal with this problem for years, and thus have developed case law to address it. The case law that is most often quoted on the distinction between repairs and capital improvements reads as follows:

“In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use.”

Despite these attempts to define the distinction between repairs and capital improvements, it is apparent that the decision will depend on the facts and circumstances of the specific situation and the actual deductions claimed.

3. The Rehabilitation Doctrine

Problems usually arise when the items which are claimed to be repairs are expended as part of a general plan of improvement, restoration, or betterment of the property.

The reality is that when one has a general plan of rehabilitation and permanent improvement of a property, expenditures which are part of this general plan, and which might otherwise constitute deductible expense for repairs, will often be a disallowed deduction.

Therefore, if you will be making expenditures which will otherwise be deductible as repairs, it is best not to undertake them at the same time that other more major expenditures are contemplated. If these repair-type expenditures are claimed as a deduction at the same time that substantial capital improvements are taking place or when there is a general plan of renovation of the building, a deduction is more likely to be denied or questioned. You would be better off trying to incur these expenses within a different taxable year. It is also a good idea to keep records (invoices, work orders, etc.) that will help you prove that the repairs claimed are separate from the extensive improvements being made.

It is very important to realize that the larger the expenditure, the greater the tendency of the government (the IRS as well as the courts) to look at it as being capital in nature (and not immediately deductible!) Although this is not universally the rule, the government usually falls into this trap. Thus, if considerable amounts for repairs are being undertaken, it may be advisable from a tax-planning standpoint to separate these expenditures over a longer period of time. In conjunction, documentation should also be made to support a future case as to why particular expenditures are in the nature of a repair. In other words, anything that you can do to help support a repair claim should be done prior to, during, and after the expenditure.

It is also important to remember that repair and maintenance deductions are among those to which IRS agents will generally pay close attention. They are instructed to require "full substantiation" in order to allow the deduction. It is up to you to prove that you actually instituted a repair and that the amount you claimed for it is correct (via a bill/receipt and cancelled check). You might also be asked to prove that the expected life of the expenditure is such that it is indeed a repair, versus a capital improvement.

4. Defending Your Repair Deduction

Again, repairs are deductible if they do not materially add to the value of your property and do not materially prolong the life of the property over the value and life of the property "before the event occurred which made the repairs necessary." If a repair was not designed to increase the value of the property, prolong its life, or adapt it to a different use, a current deduction will be allowed even for a costly outlay. In other words, the mere fact that the cost of the repair was substantial does not disqualify the deduction for a repair which otherwise would qualify.

When a broken or damaged item is replaced by a new one, the fact that the new item may have a useful life of more than one year will not necessarily bar deduction of its cost as a repair expense provided that the new item itself does not prolong the life or increase the value of the basic property.

When a city, as a safety measure or for compliance purposes, orders the property owner to replace or repair a part of a building, the cost will be held to be a currently deductible repair if the expenditure did not increase the value of the building or increase its life.

5. Pre-Rental Expense

Just because a rental unit is vacant, does not mean that you are forced to capitalize your operating expenses. You see, "if you hold your property for rental purposes, you may deduct your ordinary and necessary expenses for managing, conserving, or maintaining the property." The key is to make sure that you hold your property for rental purposes by making it available for rent (by posting a sign, running a newspaper ad, etc.). In the event that your unit remains empty, thus keeping your rental income low, it is important that you keep proof that the unit was available for rent should the deduction be challenged by the IRS.

6. Additions or Improvements to Property

In general, nondeductible capital expenditures are amounts paid or incurred to add to the value or to substantially prolong the useful life of property or to adapt the property to a new or different use. Thus, no current deduction is allowed for any such amount paid. “Face-lifting” costs which improve a property’s appearance and increase its value are also considered capital improvements. Expenditures for items that were originally capitalized, were fully depreciated, and subsequently replaced must also be capitalized.

Capitalized expenditures, which are depreciable, must now conform to the more restrictive Modified Accelerated Cost Recovery System (MACRS), which was introduced with the 1986 tax reform initiative. For residential rental property, the depreciable method and life is, by law, straight line and 27.5 years. For commercial property, the depreciable life is, by law, 39.5 years. No wonder we are aggressive with what we regard as a repair versus an improvement!

The good news is that a property owner can still break out the personal property portion of a building and receive larger depreciation deductions due to the fact that personal property items are subject to more favorable depreciation treatment. Specifically, personal property items can be classified as having a useful life of seven years (versus 27.5). For rental property owners, personal property consists of items such as capitalized: carpets; draperies and blinds; stoves; refrigerators; washing machines; garbage disposals; furniture; air conditioning units.

In closing, we would like to suggest that you do your homework whenever expending money on repairing and/or improving your property. With adequate planning and documentation, you should be able to maximize your currently deductible expenditures and support your position should there be an IRS audit. Make sure that you review your deductions and/or strategy with your tax preparer, who should be able to advise you what to do prior to the expenditure, as well as how to best document the expenditure for your records and tax returns.

RealTax professionals have the competence and experience to help you maximize your repair deductions. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.