Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you have to depreciate improvements over as many as 27.5 years.
For example, if you classify a $1,000 expense as a repair, you get to deduct $1,000 this year. If you classify it as an improvement, you'll likely have to depreciate it over 27.5 years and you'll get only a $35 deduction this year.
That's a big difference.
Unfortunately, telling the difference between a repair and an improvement can be difficult. In attempt to clarify matters, the IRS has issued lengthy regulations explaining how to tell the difference between repairs and improvements. Implementation of these rules was delayed but they became effective on January 1, 2014.
For more details on current vs. capital expenses refer to the article Current vs Capital Expenses.
If You are a Landlord
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What Is an Improvement under IRS Rules?
Under the new IRS regulations, property is improved whenever it undergoes a:
- Adaptation, or
Think of the acronym B A R = Improvement = Depreciate.
If the need for the expense was caused by a particular event--for example, a storm--you must compare the property's condition just before the event and just after the work was done to make your determination. On the other hand, if you’re correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you’ve never had any work done on the property, use its condition when placed in service as your point of comparison.
An expenditure is for a betterment if it:
- ameliorates a “material condition or defect” in the property that existed before it was acquired or when it was produced--it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
- results in a “material addition” to the property--for example, physically enlarges, expands, or extends it, or
- results in a “material increase” in the property's capacity, productivity, strength, or quality.
An expenditure is for a restoration if it:
- returns a property that has fallen into disrepair to its “ordinarily efficient operating condition”
- rebuilds the property to a like-new condition after the end of its economic useful life, or
- replaces a major component or substantial structural part of the property
- replaces a component of a property for which the owner has taken a loss, or
- repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.
You must also depreciate amounts you spend to adapt property to a new or different use. A use is “new or different” if it is not consistent with your “intended ordinary use” of the property when you originally placed it into service.
What Does the IRS Consider a Unit of Property (UOP)?
To determine whether you’ve improved your business or rental property, you must determine what the property consists of. The IRS calls this the “unit of property” (UOP). How the UOP is defined is crucial. The larger the UOP, the more likely will work done on a component be a deductible repair rather than an improvement that must be depreciated.
For example, if the UOP for an apartment building is defined as the entire building structure as a whole, you could plausibly claim that replacing the fire escapes is a repair since it doesn’t seem that significant when compared with the whole building. On the other hand, if the UOP consists of the fire protection system alone, replacing fire escapes would likely be an improvement.
New IRS regulations require that buildings be divided up into as many as nine different UOPs: the entire structure and up to eight separate building systems. An improvement to any of these UOPs must be depreciated. As a result, more costs will have to be classified as improvements, rather than repairs.
UOP #1: The Entire Building
The entire building and its structural components as a whole are a single UOP. A building’s structural components include:
- walls, partitions, floors, and ceilings, and any permanent coverings on them such as paneling or tiling
- windows and doors
- all central air conditioning or heating system components
- plumbing and plumbing fixtures, such as sinks and bathtubs
- electric wiring and lighting fixtures
- stairs, escalators, and elevators
- sprinkler systems
- fire escapes
- other components relating to the operation or maintenance of the building, and
For example, replacement of a building’s roof is an improvement to the building UOP.
UOP #2-9: Building Systems
In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems and must be depreciated:
- Heating, ventilation, and air conditioning (“HVAC”) systems: This includes motors, compressors, boilers, furnace, chillers, pipes, ducts, and radiators.
- Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.
- Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.
- All escalators.
- All elevators.
- Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers and hoses.
- Security systems: These include window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit.
- Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property line and between buildings.
Example: A landlord purchased an apartment building five years ago for $750,000. This year he spends $5,000 to fix wiring in the electrical system. Under the old IRS rules, the $5,000 likely would be considered a repair because it is relatively small compared to the overall cost of the building, which was treated as a single UOP. Under the new rules, the electrical system is a separate UOP. This means that the $5,000 must be compared with the cost of the electrical system alone, not the cost of the whole building. This makes the expense seem much more significant and likely to constitute an improvement.
For the latest IRS rules on repairs and improvements, see IRS Bulletin 2012-14, Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.