Repairs are fully deductible against all types of income including ordinary income, including your spouse’s income on a joint return. On the other hand, a “capital improvement” is not fully deductible all in one year but must be depreciated over a recovery period of 27-1/2 years for residential real property and even longer at 39 years for nonresidential real property. Personal property is depreciable over 5 or 7 years.
EXAMPLE: The owner of a rental property is in the 31% tax bracket and pays $10,000 as a repair. Consequently, the owner gets an immediate deduction which is worth $3,100 in tax savings (31% X $10,000).
However, if the $10,000 is a capital expenditure to residential rental property, then the $10,000 is written off over 27-1/2 years which gives an annual deduction of about $360 year. In this scenario the tax savings are only $112 in the first year and in the subsequent 26-1/2 years ($360 x 31%). In the first year, this amounts to a difference in tax savings of almost $3,000! These tax savings can then be used as an immediate source of down monies for other income-producing properties.
Rental property losses can offset other income, including your spouse’s income (on a joint return). Fully deductible repairs create or increases rental losses.
EXAMPLE: Your rental property is showing net taxable income of $10,000. In a 31% bracket you would owe $3,100 in taxes. Assume you also have $20,000 of expenditures that you classify as repairs.
Consequently, the $10,000 taxable income will now be a net rental loss of $10,000, which can be used to offset your other income (salaries, business income, interest, etc.). Now you have the opposite, $3,000 in tax savings.
NOL – Another part of this advantage is an NOL (Net Operating loss). An “NOL” originates from business losses (including rental property losses) in excess of all of your other income, creating a negative taxable income. The benefit of an NOL is that it can be carried back to recoup past due taxes or carried forward to offset future taxable income (and save taxes).
Deductible repairs are business expenses, which increase business losses and an NOL. Thus, the more deductible repairs you have, the higher the NOL For a further discussion of NOL’s (including favorable updates).
Because repair expenditures could be leveraged (such as with a rehab loan), such leveraged deductions do not require the outlay of cash. This is similar to depreciation; thus making repairs part of the componentizing system.However, there may be times where it is better to classify items as capital improvements instead of deductible repairs.
REPAIRS VS. IMPROVEMENTS
While the following are not the final say on deciding on a repair versus an improvement, they can be useful guidelines in doing so.
Repairs In General: Deductible repairs are those that keep the property in an ordinary, efficient operating condition, Reg. 1.162-4. Labor, supplies and incidental repairs are deductible business expenses, Reg. 1.162-1(a). Temporary and incidental expenditures, especially annual expenditures which are intended to last for less than a year, are generally repairs. Included here is maintenance, Reg. 1.263(a)-1(b).
IRS pub. 527 lists the following as examples of repairs – Repainting inside or out, fixing gutters or floors, fixing leaks, plastering and replacing broken windows. Minor expenditures in replacing small parts are generally repairs, Libby & Blouin Ltd, (1926) 4 BTA 910 (A). Thus, replacing small parts to a heating system may be considered fully deductible repairs, based on these guidelines.
Capital Improvements In General: These include new additions to a building and other major renovations or construction, IRC 263; Human Engineering Institute,TC Memo 1978-45; LaPoint, (1990) 94 TC 733.
Expenditures to adapt a property to a new or different use are capital, Reg.1.263(a)-1(b). Capitalization is required for equipment, furniture and fixtures*, if it has a useful life of more than one year, Reg. 1.263(a)-2(a); Joseph J. Otis, 73 TC 671. Examples are appliances, air conditioners, carpets and other personal property items. *Such equipment and appliances are 5year personal property. Repairs to such equipment should be fully deductible.
The burden is on the taxpayer to prove the classification of items as repairs. In addition, repairs and maintenance deductions are often closely scrutinized by IRS agents. However, dramatic tax savings can frequently be attained by the imaginative structuring of real estate transactions. The area of repairs versus capital improvements is no exception. Expenditures that appear to be “capital” at first glance, may be restructured and documented to be classified as deductible repairs. The next several chapters reveal powerful planning strategies to maximize repairs deductions.