Deducting Rental Property Maintenance Expenses

Owning a rental property involves ongoing expenditures to maintain its condition for tenants. How these costs are categorized for tax purposes significantly affects your taxable income, making it important to understand the rules for deducting them.

Differentiating Repairs from Improvements

The Internal Revenue Service (IRS) distinguishes between repairs and improvements. Repairs are currently deductible from rental income in the year paid. An improvement must be capitalized, and its cost is recovered over time through depreciation.

The IRS uses the “BAR” test, which stands for Betterment, Adaptation, and Restoration, to make this distinction. An expense is an improvement if it meets any of these criteria.

Betterment

A “Betterment” remedies a pre-existing defect, results in a material addition, or increases capacity, strength, or quality. For example, fixing faulty wiring that existed at purchase is a betterment. Replacing an entire roof with higher-quality material is also a betterment.

Adaptation

“Adaptation” modifies a property for a use inconsistent with its original purpose. An example is converting part of a residential unit into a commercial office space. These conversion costs must be capitalized as an adaptation.

Restoration

“Restoration” replaces a significant structural part of the property or rebuilds it to a like-new condition. Replacing an entire HVAC system is a restoration. The cost to restore a property after a casualty loss is also a restoration.

Common Deductible Repair and Maintenance Expenses

Expenses that keep your property in good operating condition without materially adding to its value or prolonging its life are deductible in the year they are incurred. Common examples include:

• Interior and exterior painting
• Patching drywall or fixing cracks in plaster
• Repairing broken locks
• Fixing leaking faucets or clearing clogged drains
• Repairing a faulty light switch
• Pest control services
• Landscaping services, such as lawn mowing
• Cleaning costs between tenants
• Repairing a broken appliance to its previous working condition

Understanding Capital Improvements and Depreciation

An expense classified as an improvement must be capitalized by adding it to the property’s cost basis. The cost is recovered over time through annual depreciation deductions.

For residential rental properties, the recovery period is 27.5 years using the straight-line method of depreciation. This method allocates an equal deduction to each full year the property is in service.

For example, a new $11,000 central air conditioning system is an improvement. Dividing the cost by 27.5 years results in a $400 annual depreciation deduction.

Land is not depreciable. A property’s purchase price must be allocated between the land and the building, as only the building and its improvements can be depreciated.

Utilizing Safe Harbor Elections

The IRS offers safe harbor elections to simplify expense classification and allow immediate deductions for costs that would otherwise be capitalized. Using them requires a formal election with your tax return.

The De Minimis Safe Harbor Election allows deducting small-dollar expenditures. For taxpayers without an applicable financial statement (AFS), the threshold is $2,500 per item. This means a new $700 appliance can be deducted immediately instead of depreciated.

The Routine Maintenance Safe Harbor allows deducting expenses for recurring activities that keep a property in operating condition. To qualify, you must expect to perform the maintenance more than once every 10 years. This includes inspecting systems or replacing worn parts.

The Safe Harbor for Small Taxpayers allows qualifying taxpayers to deduct all annual expenses for repairs, maintenance, and improvements. To qualify, your average annual gross receipts must be $10 million or less, and the building’s unadjusted basis must be $1 million or less. The total annual deduction cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.

Documentation and Reporting on Tax Forms

You must properly document and report all classified expenses on your tax return. Meticulous records are required to substantiate your deductions during an IRS inquiry.

Retain documents like dated receipts, paid invoices, and bank statements. For rental-related travel, a mileage log detailing the date, mileage, and purpose of each trip is necessary. You can deduct business miles at the standard mileage rate.

Expenses are reported on IRS Form 1040, Schedule E. This form calculates your total rental income or loss. You list each property separately, reporting gross rents on line 3 and expenses on lines 5 through 19.

Deductible repairs are entered on line 14, “Repairs.” Depreciation for the property and capitalized improvements is calculated on Form 4562, Depreciation and Amortization. The total is then entered on line 18 of Schedule E.