Real estate investors can take advantage of numerous tax incentives on everything from rental properties to shopping centers. One of the biggest tax perks comes in the form of deductions. As a real estate investor, you can write off mortgage interest, property taxes, depreciation, operating expenses, and money you spend to repair or maintain the property.
You can generally deduct repairs and maintenance as ordinary business expenses the year you pay for them. However, the tax treatment of renovations works differently. If you make any renovations or improvements that increase the property's value or alter its function, you must capitalize and depreciate your expenses.
The difference between repairs and improvements
Repairs and improvements don't share the same tax treatment, so it's essential to understand the difference between the two.
In general, repairs are one-off fixes that "keep your property in an ordinarily efficient operating condition," according to the Internal Revenue Service (IRS). If you fix a leaky roof, paint the kitchen, or refinish the hardwood floors, it counts as a repair. Repairs keep your property in good working order, but they don't usually increase its value. You deduct repair costs when you file your current tax return.
Anything that adds to the value of the property or extends its life (including renovations) is considered an improvement. In general, if you add a new item, replace an old one, or upgrade an existing one, it's an improvement.
So if you replace a leaky roof -- instead of repairing it -- it counts as an improvement. Likewise, if you renovate the kitchen or install new flooring, you're looking at an improvement. These costs are capitalized as long-term assets and depreciated over multiple years.
For example, assume you spend $800 to fix a leaky roof. This is a repair, so you deduct the entire $800 on your tax return. However, say you spend $8,000 to install a new roof instead. In this case, it's an improvement, and you depreciate the entire $8,000.
Here's a quick comparison of repairs and improvements:
|Repairs (Deduct the Cost)||Improvements (Depreciate the Cost)|
|Fix a broken air conditioner||Add central air conditioning|
|Fix an appliance||Install built-in appliances|
|Fix a broken doorknob||Upgrade door hardware throughout the property|
|Replace a broken tile||Install new tile in an entire room|
|Fix a broken windowpane||Replace multiple windows|
|Have the carpets professionally cleaned||Install new wall-to-wall carpet|
|Fix a leaky roof||Replace the entire roof|
|Fix a leaky faucet||Replace all existing plumbing|
|Fix a section of electric wiring||Replace all existing wiring|
|Fix or replace a broken kitchen cabinet||Renovate the kitchen|
|Refinish the wood floors||Replace the wood floors|
|Paint a bedroom||Paint as part of a renovation|
|Fix a security camera||Install a security system|
What is depreciation?
Instead of taking one large deduction the year you buy or improve an investment property, depreciation spreads the deduction across multiple years.
Real estate investors typically use the Modified Accelerated Cost Recovery System (MACRS) depreciation method. The number of years you depreciate an investment depends on the type of property:
- You depreciate residential property over 27.5 years. These are properties you lease to individuals and families. Examples include rental houses, multifamily homes (one-to-four-unit properties), and apartment buildings.
- You depreciate commercial property over 39 years. These are income-producing properties that you lease to businesses. Examples include shopping centers, warehouses, restaurants, hotels, casinos, self-storage facilities, and office buildings.
Depreciation starts when you place the property in service and continues until:
- you've deducted your entire cost (or other basis) in the property or
- you retire the property from service.
How to depreciate renovations
Under IRS rules, you depreciate improvements using the same recovery period you use to depreciate the property. So, for example, if you install a new security system in a hotel, you depreciate the cost over 39 years since it's a commercial property. Conversely, if you replace the windows in a rental house, you depreciate over 27.5 years because it's a residential property.
You treat the improvement as separate depreciable property. The recovery period for the improvement starts on the later of:
- the date the improvement is placed in service or
- the date the improved property is placed in service.
Safe harbor for small taxpayers
Residential investors may be able to take advantage of IRS safe harbor rules that let smaller taxpayers deduct -- rather than depreciate -- up to $10,000 of improvements per rental building or unit. To do so, you must make the election to use the safe harbor for each taxable year and meet certain limits:
- The property must have a cost basis of $1 million or less.
- The total amount you paid for repairs, maintenance, improvements, and similar expenses can't exceed $10,000 or 2% of the property's cost basis, whichever is less.
- Your average annual gross receipts from the previous three years must be $10 million or less.
Get help when you need it
Whether you're doing repairs or improvements, keep good records. You'll need to know the cost of any improvements when you sell the property.
Also, keep in mind that some projects don't fit neatly into either the repair or improvement category. For example, if you fix a leaky pipe, it's a repair. And if you replace all the plumbing, it's an improvement. But what if you replace half of the property's plumbing? Gray areas like this are best left to the expertise -- and interpretation -- of your tax accountant.
Tax laws are complicated and they change from time to time. Different rules may apply to your situation. It's always a good idea to work closely with a tax accountant who can make sure you're in compliance and that you're getting the most favorable tax treatment possible.