Maintenance or Capital Improvement? What is the difference & why does it matter?
This is a tricky question with both grey areas and serious tax implications. A lot of people think all repairs are maintenance because a “maintenance person” does them. Your maintenance people are likely making some capital improvements too. If you haven’t been separating capital improvements on your tax return – when the day comes that you sell your property you might be in for a surprise! Use this guide to understand the difference:
- “Maintenance” as it is named is simply that, and is not deemed a significant improvement in value to the property. These are generally smaller repairs, including carpet, painting, and wall repair and landscaping. Carpet, paint, window coverings, landscaping are all improvements that have a relatively short life time (even though they seem expensive in some instances) and are not considered a capital improvement.
- “Capital Improvements” are deemed improvements to the property value. Typically if you are “replacing” something vs. fixing it or refinishing it, it would be a capital improvement. A small value item such as if you replaced a toilet it would likely be deemed maintenance, but if you remodeled a bathroom including a new toilet the entire expense would be deemed a capital improvement. Roofing, siding, windows, bathroom or kitchen remodels, new tile or wood flooring, new cabinets, concrete/asphalt, garages, decks, appliances or mechanicals would all be capital improvements.
Some items fall into the grey area where they can go either way. An example is a thorough repainting and new carpet. This costs several thousand dollars and it definitely is a large improvement, however, paint and carpet typically don’t count for capital improvements because they don’t last as long. Now, say you remodeled the entire apartment, new bath, new kitchen, etc., and you also paint and put new carpet in. In this case it is very plausible all of this would be a capital improvement. The paint and carpet are maintenance items, but they were simply parts to a much larger project that will have a longer life.
Case study, why does it matter?
When you purchased your property, the purchase price off the HUD will go on your tax return as your basis which is “tax speak” for value. Maintenance expenses are used as an expense in full the year they occur. Capital improvements are added to the basis of the property. This basis number, divided by 27.5 years, is your depreciation expense on your tax return.
Now let’s look at a real world example. You purchased a house for 50k and do a 30k remodel on it, and refinance your loan for 80k. Three years later you decide to sell the property for 100k. Naturally, you feel you’ve made 20k on the property. Likely you still owe close to that amount. If you expensed the remodel as maintenance in year 1 (this is tempting as you would avoid paying a chunk of income taxes this year) your basis would be 44.5k (50k -3 years of depreciation) and you will have to pay capital gains tax on 55.5k the year the property sells, likely wiping out your entire gain at the sale.
So if you’re wondering how to be sure you’re adding to your basis each year, luckily it’s pretty simple. Take a look at your expenses for the year and break them into a total for each category. List the capital improvement on your tax return as an increase in basis, or make sure your tax preparer knows both amounts so they can account for them correctly.