Understanding the difference between capital improvements and repairs on your rental property is critical when reporting your tax deductions. The reason is that distinct tax laws apply to these expenses: capital improvements are depreciated over time, while repairs are fully deductible in the year that the repair was done. This distinction can significantly impact how much tax you pay on your property’s earnings and how you make financial decisions for your rental business.
Whether replacing worn-out components in your HVAC unit or preparing for a major kitchen overhaul, our guide will help you classify your expenses correctly. That way, you can maximize your tax deductions while complying with tax laws.
What are capital improvements to a rental property?
A capital improvement is an expenditure that increases your rental property’s value or makes it better. Unlike ongoing repairs and maintenance, which you perform to keep your property in good working order, capital improvements upgrade your property and boost its overall market worth. Capital improvements are also referred to as capital expenditures, capital costs, or capital expenses.
That’s the general definition of capital improvement. But for tax purposes, capital improvements encompass more than an arbitrary increase in your property’s value. According to IRS Publication 523, a capital improvement “adds to the value of your home, prolongs its useful life, or adapts it to new uses.”
In Canada, tax authorities define capital improvements as “renovations and expenses that extend the useful life of your property or improve it beyond its original condition.”
Besides the tax definitions, there are other ways you can identify a capital improvement:
- Expensive: It typically requires a significant upfront investment, anywhere from a few thousand dollars to hundreds of thousands. Many landlords establish reserve funds to ensure they have the money to pay for a capital expense.
- Complex and time-consuming: It demands significant time and attention to complete, regardless of whether you do the work personally or hire professionals.
- Infrequent: Capital improvements provide lasting benefits that last many years. As such, they’re not something you’ll attend to routinely as a landlord or property owner.
The rules governing what constitutes a capital investment can be fuzzy. Consult a tax expert for guidance if you’re unsure whether an expense is a capital improvement or repair. You can also review the criteria used by the Internal Revenue Service (IRS) and Canada Revenue Agency (CRA) to identify capital investments. We’ve compiled some helpful resources you can refer to later in this article.
What is considered a rental repair?
Repairs are routine preventative maintenance to keep your rental property in working order. These quick fixes and touch-ups preserve a property’s current condition and ensure it operates smoothly on a daily basis.
Unlike capital improvements, repairs don’t add significant value to your property, nor do they alter it for a new use or extend its useful life. The cost for repairs is relatively low, requiring minimal time and effort to carry out.
Since repairs are recurring expenses, you must attend to them more frequently. For this reason, creating and following a rental property maintenance schedule can help you stay organized.
Examples of capital improvements vs. repairs for rental properties
The table below is a quick comparison of capital improvements and repairs for rental properties that highlights the difference in scope.
Capital Improvements
Repairs
Adding a new bathroom
Replacing chipped bathroom tiles
Renovating the kitchen
Fixing a leaky kitchen sink faucet
Replacing the HVAC system
Replacing minor parts in the HVAC system
Installing new flooring
Patching a small section of a damaged carpet
Upgrading all the windows to energy-efficient ones
Replacing a broken window
Replacing the entire roof
Patching a hole in the roof
Certain items purchased for use in your rental also fall under capital improvements. Some examples include furniture, equipment, and appliances.
Tax treatment of capital improvements
Capital improvements are depreciated over time, which means their cost is spread over their useful life. In other words, you can’t write off the total cost in the current tax year. Instead, you claim a portion each year as an expense against your rental income.
General depreciation system in the U.S.
Most rental property improvements in the U.S. are depreciated under the General Depreciation System (GDS). Under this accounting method, you spread the cost of your improvement over 27.5 years. For example, if you spent $20,000 on a kitchen renovation, you could claim a maximum of $727.27 annually ($20,000 divided by 27.5).
Some improvements may qualify for shorter depreciation periods, so be sure to review the guidance from the IRS or consult with a tax professional.
Capital cost allowance in Canada
Let’s assume you own a rental property in Canada. In that case, you must follow the rules for deducting depreciation under a system called capital cost allowance (CCA). Under this system, the CRA divides assets into different classes, each of which gets depreciated at a specific rate. Most rental improvements fall into Class 4, which has a 4% depreciation rate.
Using our previous kitchen renovation example, the maximum amount allowed as a tax deduction in the first year would be $800 ($20,000 multiplied by 0.04). In the following year, you’d deduct $800 from your initial cost of $20,000 and repeat the calculation. Your allowable depreciation in the second year would be $768 (($20,000 minus $800) multiplied by 0.04).
The bottom line on capital improvements
Be careful not to categorize a repair as a capital improvement mistakenly. Otherwise, you’ll overstate your expenses and risk getting hit with a surprise tax bill if you get audited.
Capital improvements require a significant upfront investment, but they can enhance the long-term value of your property and boost its appeal among tenants. While you won’t get an immediate deduction for the whole amount, depreciation offers valuable tax benefits for many years. Knowing how much of your improvements’ total cost qualifies as a tax deduction annually can help you budget more effectively and make better investment decisions.
To learn more about calculating depreciation for rental improvements, check these guides:
- How to Calculate Rental Property Depreciation in the U.S.
- What is Rental Property Depreciation in Canada (And How Do You Calculate It)?
Tax treatment of repairs
Rental property repairs are more straightforward to deal with from a tax perspective, since you can deduct the total cost of repairs and maintenance incurred during the year. Since the typical life expectancy of repair work rarely exceeds a year, they’re not subject to depreciation like capital improvements.
Given the favorable tax treatment of repairs, you can potentially use them to lower your tax burden. Therefore, ensure you track these expenses closely and avoid misclassifying them as capital improvements, which are written off gradually over many years.
Learn more about capital improvements vs. repairs
Navigating the tax laws surrounding these capital improvements and repairs can be trickier in practice than it may seem, as there are many nuances and exceptions.
Sometimes, it’s unclear whether an activity is a capital improvement or repair. If you make the wrong choice, you risk getting hit with an unexpected tax bill and penalties.
To learn about classifying rental expenses as either capital improvements or repairs correctly, check out the following resources:
For the U.S.
- IRS – Tangible property regulations: A comprehensive collection of FAQs that explain how to distinguish between capital investments and repairs. It also covers exceptions like the Safe Harbor Election and Safe Harbor for Routine Maintenance, which allow you to treat improvements as ordinary repairs for tax purposes.
- IRS Publication 527: This handy guide breaks down how to calculate and report rental income and expenses to the IRS, including depreciation for capital improvements.
- IRS Publication 946: Another valuable resource that clarifies how to depreciate property, including residential rental units.
For Canada
- Government of Canada – Current expense or capital expenses. This brief guide outlines the criteria to determine whether an expense qualifies as a capital improvement or repair. Be sure to check out the section at the bottom that addresses special situations regarding improvements.
- Government of Canada – Capital cost allowance (CCA) for rental property: This guide provides a solid overview of CCA for rental properties, including the amount of CCA you can claim and how to calculate it.
Our final thoughts
As a landlord or property owner, it’s essential to differentiate between capital improvements and repairs. Both expenditures affect your rental property’s tax deductions, but they do so in different ways.
Capital improvements are expenses that significantly increase your rental’s value, improve it beyond its original condition, or extend its useful life. Because they provide lasting benefits, you must depreciate them over time rather than claim the total cost in the current year.
Repairs address damages due to wear and tear and help keep your property functional. Because they don’t add significant value to the property, they’re fully deductible in the year you pay for them.
Given the distinct tax treatment of capital improvements and repairs, keeping detailed records of transactions and work done will make it easier to report deductions during tax season. Track your expenses effectively with our rental property expenses sheet.
