The distinction between repair expenses and improvement costs can impact your tax benefits.
The tax law categorizes repair and improvement costs differently. Repair expenses are generally more beneficial for tax purposes, providing greater after-tax cash value than the depreciation deductions you would get from improvements or additions.
One key reason for this is recapture taxes. When you depreciate a building and then sell it at a profit, a percentage (up to 25 percent) of the straight-line depreciation you claimed on the building is taxed as “unrecaptured Section 1250 gain.” This effectively transforms what you might have considered deductions into something resembling a profit-sharing loan from the IRS, which is repayable upon sale.
Further, depreciation deductions come in small parts over long durations—27.5 years for residential rental properties and 39 years for commercial properties. In comparison, repair expenses can provide immediate tax benefits, depending on how the passive loss rules affect you.
Example. If you spent $30,000 on repairs to your business building and are in the 28 percent tax bracket, you could save $8,400. On the other hand, if you classified the same $30,000 as a capital expenditure (improvement), you would deduct depreciation and save approximately $215 a year.
And this $215 per year is not really $215 a year because it does not consider
- the time value of money, or
- the devastating effect of recapture taxes.
If you would like my help distinguishing between repairs and improvements, please contact us here.