If you have direct ownership of a property used for business or investment, there could come a time when you might want to make a change to it. You might want to add an addition or refloor the asset. These are activities that fall under the category of capital improvement.
Capital improvement by itself is fairly straightforward, but it can often be confused with the repair or maintenance of a property. As such, it’s important to understand the purpose and definition of a capital improvement, as it can impact how you report the expense on your tax return.
Capital Improvement or Repair?
A capital improvement is defined as a major expense used to improve a fixed asset. Going further, a fixed asset isn’t necessarily fixed in place but rather, is measured by time. Specifically, fixed assets consist of property and/or equipment owned for longer than one year. As an aside, fixed assets are different from inventory in that they can be depreciated over their lifetime.
There can be some confusion about the differences between a capital improvement and repair/maintenance expenses. Earmarking money for property or other assets is considered capital improvement if:
- It extends the asset’s useful life
- It boosts the asset’s overall value
- It adapts the asset for different usages
An easy way to remember the capital improvement definition under IRS rules is BAR, specifically:
- B for “betterment”
- A for “adaptation”
- R for “restoration”
Here’s an example. If you replace an entire roof on your rental property, this is a capital improvement. The expense extends the building’s useful life and could improve its value.
On the other hand, replacing a couple of shingles from the roof is considered a repair and maintenance expense. A repair expense restores an asset to working condition but doesn’t necessarily improve on its previous quality or usefulness. Fixing shingles means the roof is protecting your structure as it did before. Replacing the entire roof, however, adds improvement and (potentially) longevity.
What to Tell the IRS
As mentioned above, understanding capital improvements is important to help you know what to declare on your tax return. Repairs that keep properties in good running condition are deducted as expenses in the year in which it was paid for. But capital improvements are managed differently. The improvement costs are depreciated over the property’s useful life (27.5 years for residential properties and 39 years for commercial assets).
Capital improvements might also come into play when it comes time to sell the property. At that time, the costs you accrued when bettering, adapting, or restoring the property might be added to the property’s cost basis (in other words, what you originally paid for the property).
Gray Areas
While the definition of capital improvement is fairly straightforward, its application can be a little confusing. For example, tacked-down carpeting is considered personal property; costs might be depreciated over five years. But if that carpet is glued down, it’s considered part of the building’s structure, meaning the cost for its replacement is spread out over 27.5 years.
Because of the complexity of capital improvements, it’s a good idea to consult a tax professional for any questions on this issue.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
