Rental property owners who are considering whether they should renovate and upgrade their property should consider how improvements to their property might affect their taxes. There is an important distinction to be made between improvements vs repairs, and smart landlords should be aware of which can work best for them.
Renovating a rental property can have a number of advantages, from tenant retention and improved monthly cash flow to the long-term raising of the property value, but doing so is not without cost. While there is the obvious short-term cost of the construction, one of the biggest costs associated with renovations that can ambush some landlords is taxes. But not all construction work needs to be classified as a renovation.
It doesn't matter if you are looking to upgrade a small single-family rental property, a larger multifamily building, or even just doing a quick refresh on a short-term rental property; having a proper understanding of the difference between improvements vs repairs is crucial for landlords. New capital improvements to a property can often affect your taxable income, depreciation schedule and the general return on investment that you are likely to see from your property.
Let's take a closer look at some of the important things that landlords should know about renovating rental properties, including the potential depreciation after renovation, the usefulness of preparing with a cost segregation calculator and some ways that landlords can use tax laws to their advantage.
What Are The Differences Between Improvements vs Repairs?
The key differences between improvements to a property and repairs are that improvements are typically things that will add value, adpat it's use or extend the useful life of the property, while repairs are things that will keep it in good operating condition.
Capital improvements are typically not deducted immediately, but are capitalized and depreciated over time. Some examples of common capital improvements to properties can include:
- Remodels of kitchens or bathrooms.
- Adding new outdoor amenities like a pool or patio.
- A new roof installation.
- Flooring replacement.
- New plumbing.
- Additional electrical systems.
Repairs, however, are typically deductible as they occur and are likely to include things like:
- Repainting damaged areas.
- Roof repairs.
- Replacing tiles that are broken.
- Replacement or repair of faucets.
- Upkeep and service of HVAC and other such systems.
It is important to know the difference between improvements vs repairs, as they will change the way that you are taxed. Landlords looking at the viability of adding a pool or any other rental property renovation might want to consider the tax ramifications of performing capital improvements, but should be aware of how depreciation after renovation is likely to change.
How Can Renovations Be Used As a New Depreciable Basis
In a nutshell, as landlords undertake rental property renovation, whatever those improvements cost is added to the basis value of the property. This becomes the new depreciable basis of the property, and can be used for tax deductions over the coming years.
Let's say that, for example, a landlord buys a rental property at $400,000, and then spends $100,000 to renovate it. Instead of the full $100,000 being deducted immediately from their current year's taxes, those costs are depreciated over time, as long as they meet the correct classification. But such a thing can be complicated to organize advantageously, which is why a cost segregation study can be so useful.
What Exactly Is a Cost Segregation Study?
A cost segregation study is a strategy whereby the various components of a property can be depreciated through tax in a shorter period of time, instead of the normal 27.5 or 39 years, depending on the type of property. In essence, landlords can use a cost segregation study to separate different components of a property into accelerated depreciation categories, reducing their tax burden at a faster rate.
There are a wide variety of caveats and qualifiers that exist, but using cost segregation study services can help elucidate to landlords all the details. The end result of a cost segregation study should be tax deductions for landlords.
Using an Online Cost Segregation Calculator Before Hiring a Provider
While hiring a provider to run a cost segregation study is the safest option, it can be a sound strategic choice to run the numbers through an online cost segregation calculator first. Doing so will give landlords a preliminary estimate that will allow them to fine-tune their renovation tax strategies going forward. Online cost segregation calculators are likely to need information like:
- Renovation budget.
- Building age.
- Allocation of value to land.
- Type of property.
- Original purchase price.
It is important to note that the preliminary estimates are just that, estimates. But they can help landlords to narrow their focus and understand whether or not a full cost segregation study is worthwhile. While a cost segregation study can be expensive, it is likely to net tax deductions for landlords that more than make up for the cost.
Using the Short-Term Rental Tax Strategy
For landlords who are all-in on materially participating in the rental activities of their properties, there is one strategy for tax deductions for landlords that is known as the STR loophole. This strategy involves using a short-term rental tax loophole and can be very profitable for landlords who are willing to put in the time to incorporate it into their tax strategy.
For the most part, rental losses are considered to be passive and, especially for high-income taxpayers, are likely to be limited. But when the average guest stay is seven days or less, those stays may not count as rental activities under the IRS's rules.
So, how can a property owner achieve this strategy? They must pass one of a number of tests that the IRS provides to prove material participation, the most commonly passed of which is the 100-hour test. The 100-hour test simply requires that the property owner participate for at least 100 hours for a property, with no other individual participating more. Which is something that any homeowner with a little extra time on their hands can achieve.
While this strategy does require a property owner to invest a not-insignificant amount of time in the management of the rental property, they may find that cost segregation and losses from accelerated depreciation can offset non-passive income.
Planning to Renovate Means Planning For Taxes
Any landlords who are looking at rental property renovation must understand the differences between improvements vs repairs, and should be factoring any changes they are going to make into their overall tax strategy. Smart landlords can make use of the depreciation after renovation to offset their taxable income for years to come, or can use a cost segregation study to accelerate that depreciation and acquire more tangible tax offsets sooner.
The planning stage of any renovation project should include an overview of how that project might affect the landlord's tax situation, and how those changes can be turned to the landlord's advantage.
