Capital Improvements vs. Repairs – What’s the Difference?

We are going to dive into capital improvements vs. expenses today. What are they? What are the tax implications? Should you care about the difference?

Expense Categories for your Rental Property

If you own rental properties, you are going to have expenses associated with your units. Hopefully, most will be small, but occasionally there will be expensive costs that will feel like a punch to the gut. The Stealthy Rich keep careful track of all expenses and place them into one of two categories:

1. Repairs (Plain ‘ole expenses)
2. Capital Improvements (Capital Expenses)

Why are these two categories important?  They are essential because the IRS treats them differently for tax purposes.

What are Repair Expenses?

Everyday expenses can be deducted right away against your income in the year that you pay for the expense. This type of expense means you get the benefit NOW and will pay LESS tax to Uncle Sam in the year you incur the expense.

What is a Capital Improvement?

Capital improvements are treated differently for tax purposes. You must depreciate those improvement costs over several years, which means if you drop $10,000 on a new roof, you won’t be able to deduct that $10,000 in the same year against your income. Instead, you can deduct a portion of that $10,000 each year for a predetermined number of years until you’ve depreciated the entire amount. Then if you ever sell the property, you will need to “recapture” a percentage of that depreciation as a tax to the government. This “recapture amount can be from roughly 20% and up to 25% of the depreciated amount. Your total taxable income, and whether you sold the asset for a profit will determine how much recapture you have to pay.

The IRS has several categories to help you determine if you have a capital expense on your hands.  If you do, you then must depreciate it over a specific schedule and can’t take the deduction in the same year. A good rule of thumb is if you are replacing something major, it’s probably an “improvement.” There are a few categories into which the IRS breaks down improvements.

• Betterments – This is just a fancy word for expenses that make your rental property significantly better. These include expenses for fixing pre-existing defects or increasing the size, durability, or quality of the unit.
• Restorations – These are expenses that are for repairing damage to your property after you file an insurance claim, or rebuilding your property to a like-new condition, or replacing a substantial part of your property.
• Adaptation. This improvement occurs if you spend significant money to change how the property is used.

Here are some examples of  expenses and capital improvements:

The Stealthy Rich and Capital Improvements

Capital expenditures (CAPEX)  can be scary to some because these costs can get prohibitively expensive if you are not careful. We typically buy older homes that have more deferred maintenance, which means there is a potential for a ton of CAPEX surprises in store for us.

We’ve been tracking our capital improvements since the beginning, so we know precisely how many HVACs, floors, roofs, water heaters, appliances, etc. This calculation is helpful so that we know exactly how “old” our major systems are. This way, we can see how “restored” our whole portfolio is. The chart below is a little misleading as it doesn’t count improvements that were made before we purchased the properties. For example, several of our homes had new roofs installed the year or two before we took ownership. Hopefully, we won’t be replacing those for a long time!

We know our CAPEX costs explicitly. that a roof costs us $6,500, a tub is $2,000, new floors are about $3,500. An HVAC is $2,000 per piece (There are three pieces, coil, condenser, and Furnace/air handler). If we plan, we can have sufficient cash reserves when these improvements need to be made without causing financial hardship for us.

A recent example on House #56, we needed to replace the roof. The roof ended up costing about $5,200. The old roof was leaky and had a ton of rot in it. We’d love to be able to deduct all $5,200 of our taxes for 2020, but unfortunately, this is clearly a replacement, and we will have to, instead, depreciate the roof over the years. (And then pay the depreciation recapture if we ever sell the property.) However, our basis in the property also goes up with this improvement since it is a capital expense.  So that roof will save us 5,200 *15% or $780 plus a good chunk of the $5,200 of which we can depreciate over the next years. (A small piece of that depreciation we will have to pay back as recapture if we sell the property.)

The Stealthy Rich CAPEX Tracking

We track every capital expense on all our properties. This way, we know precisely how “healthy” each property is. As you can see, we’ve replaced about 60% of our floors. We only count the improvements for which we have done ourselves, so some improvements were made right before we purchased properties that we did not account for here.

Get a Tax Professional

Hopefully, by reading this, you realize the importance of having a fantastic CPA. We have one who does all of these complicated calculations for us. We send him our expenses, and he knows how to depreciate them, change our basis, and make sure we are getting our maximum tax shelters in place. Make sure to secure an excellent tax professional if you own any rentals. We love ours!