Of the things people least like to do, I’d wager that suffering through an IRS audit would be near the top of everyone’s list. Having a government official pour over all of your records and question you about what you did on hundreds of transactions… Yikes! Getting a root canal done with no anesthesia sounds a whole lot more appealing.
I hope you never have to endure that miserable experience. However, if you do get audited, the last thing you want to hear at the end of the process from your IRS examiner is, “Please write the United States Government a check for thousands of dollars.”
Landlords can run afoul of the tax code by mischaracterizing repairs, maintenance, and improvements expenditures. As we all know, repairs and maintenance done on a rental property are deductible expenses, so they reduce our income and therefore lower our tax bill. But if you make improvements to a rental property, the money spent is not an immediately deductible expense. It’s treated differently by the IRS.
No, you don’t need to call your accountant every time you fix a leaky faucet. But you do need to keep the differences between maintenance, repairs, and improvements in mind as you create and organize your financial records.
Let’s start by defining terms.
Maintenance is any job done to resolve existing degeneration or prevent damage. The goal is to keep existing property functioning. For example, routine servicing of HVAC units is maintenance. Installing a new HVAC system is not.
Repairs are any work done to fix damage and deterioration. The goal of any repair is to restore the property to the condition it was in before the damage occurred. Sticking with our HVAC example, calling a service company to come out and fix a damaged line on an air conditioning condenser is a repair.
Capital Improvements are any work done to better the state of your property beyond its original condition. They increase the value of the property, extend its expected life, and raise the property’s income-producing capability.
Using our HVAC scenario, if you replaced an old HVAC unit with a new one, that’s a capital improvement. Other typical capital improvements are things like additions, extensions, remodeling, and renovations.
Capital improvements are not expenses under the tax code. In fact, the IRS (you gotta love these guys, right?) has four separate categories of capital improvements – Betterments, Improvements, Restoration, and Adaptation. Let’s not get in the weeds here; that’s your accountant’s job. But understand this – landlords can deduct 100% of repairs and maintenance costs in the year they occur. The cost of capital expenditures must be depreciated over time – spread over 27.5 years, to be precise.
If you categorize a capital improvement as an expense on your tax return and the IRS notices this mischaracterization, your income for that year will rise. That means you’ll pay more taxes. It could also mean that you are liable for penalties and interest on your unpaid tax bill.
The line between capital expenditures and expenses can get blurry. Here’s an example. If you decide that it’s time to replace all of your old windows with new energy-efficient ones, that’s a capital expense because by doing this, you are increasing the usable lifespan of your rental property. If a storm causes some tree limbs to break off and those loose limbs shatter three windows on your rental, and you replace those old windows with new ones, that’s a repair.
For many reasons, unless you’re an attorney or accountant, hire a pro to advise you and do your taxes. The first thing they will tell you to do is this – keep accurate records. Have an argument ready to justify all expenses you claim in a tax year. Save all of your receipts, invoices, and any other proof of what you did and why it was done.
While REIs (Real Estate Investors) have to pay taxes like everyone else, it is also true that we enjoy some sweeping tax deductions. For example, we can often write off closing costs on transactions, landlord insurance, property taxes, property management fees, and more. It’s fair to say that we enjoy tax savings that other investors cannot access – that’s just the way it is.
That said, be smart. The IRS doesn’t care if you’re a new landlord or if you had the best of intentions and just messed up – if they audit you and you’ve been sloppy or careless with how you’ve characterized your expenses, you will be paying the bill.
Please do not consider any information or opinion I’ve given you here as being definitive on how you should handle your tax obligations. Do consult with an accountant or attorney. Always use a pro to complete your tax return.
At Sterling Property Solutions, we have a team in place that can answer all your questions and address any challenges. If you are already a landlord and no longer have the time or desire to handle rental property management on your own, we can help. Maybe your current property management company is not giving you the top-tier service you deserve. If so, reach out. We are there for you.
Please give me a ring at 914-355-3277 or send me an email at Linda@Sterlingpsi.com. Together, let’s put in place a robust, long-term program for your success.