The Tax Byte
The Tax Byte

Planning for the Tax-Free
Sale of Your Home

Increase Net Worth: Repair Business and Rental Properties; Improve Your Home

This article will help you increase your net worth if you own a home, business building, or rental property. The improvement versus repair sections of tax law contain big gray areas. With the knowledge you gain from this article, the clouded definitions provide opportunities.

Different taxpayers classify the same fix up differently. Often, it depends on the taxpayer's assertions. For example, the same fix up of a roof might be a repair to one taxpayer, but an improvement to another taxpayer.

Fixing depreciable property: Say you fix your rental or business property. You need to know that your tax classification of the fix up has big financial implications. On a business or rental property fix up, you get:

  • Maximum tax benefits if the fix up is a repair
  • Minimum tax benefits if the fix up is an improvement
Remember, the law is vague. The same fix up might be a repair to one person and an improvement to another. If you have the choice or can plan the result, you reap the financial rewards.

This article helps you make the rules work for you. It explains the rules and definitions. It helps you plan the results.

Fixing your home: Repairs to the home never reduce income taxes. Certain repairs made at the time of sale can defer tax, but such repairs do not cut the tax.

Improvements increase basis and always cut taxable gain. Therefore, given the choice to call the fix up a repair or improvement, you always want to call the fix up an improvement to your home.

Planning note: To get maximum benefits:

  • Improve your home
  • Repair your rental properties
  • Repair your business properties

Definitions

Repair: You repair when you restore to sound state or mend. The repair keeps the property in ordinary efficient operating condition. The repair:

  • Does not add to the value of property
  • Does not appreciably prolong the property's life.
The repair simply keeps the property in operating condition over its probable life for the uses for which you acquired it?

Improvement: You make an improvement when you:

  • Increase the value of the property
  • Make the property last much longer; or
  • Adapt the property to a new or different use

Use the gray areas to your advantage

The difference between a repair and an improvement rests on the "facts and circumstances" of each case. As you may suspect, there is considerable disagreement over the definitions.

For example, when does roof work cease to be a repair and become a partial replacement? In situations of this sort, careful tax planning and a thoughtful collection of evidence can yield big tax savings.

Time Value of Money

You want all fix-ups to your rental and business properties classed as repairs not improvements. You deduct repairs immediately. You depreciate improvements over more than 27 years depending on the type of property.

If you spend $10,000 on a fix up of your rental property, you deduct:

  • Either $10,000 now as a repair, or
  • $364 a year for 27.5 years.
Here's an ugly thought: The $364 each year for 27.5 years does not produce true deductions of $364 a year. There is a time value to money. If your money is worth 6% a year, the present values (today's value) of the 27.5 annual $364 write offs equals $4,840 today. Compare it this way for the true effect assuming you spend $10,000 and plan to keep the building:
  • Deduct $10,000 for the repair
  • Deduct $4,840 for the improvement
This improvement is only worth 48.4% of the repair. Business property produces even worse results because you depreciate business buildings not over 27.5 years but over 39 years.

The Jacobson Case

You can find many cases like the Jacobson case. We picked the 1983 Jacobson case because it gives a clear example of gray areas. Roger Jacobson bought a four-unit apartment for $30,000. One tenant lived in the four-plex. The building was in poor shape at the time of purchase. Jacobson spend $6,247 with a contractor to:

  • Remove tree limbs that were rubbing on the roof
  • Repair water damage
  • Repair electrical wiring
  • Clean the carpet, floors, and exterior
  • Repair the front porch
  • Install new cabinet doors
  • Install new counter tops
During an audit, the IRS incorrectly said all the work, the entire $6,247, was an improvement. Jacobson disagreed and looked to the courts for a more favorable opinion.

The Tax Court allowed $5,000 as repair deductions. The court made Jacobson capitalize $1,247 for the "new" cabinet doors and the "new" counter tops. In siding with Jacobson, the court noted that:

  • There was a tenant in the residence
  • The presence of the tenant meant that the property was commercially active
  • $6,247 in total and the $5,000 allowed were not material based on a $30,000 price
Planning note 1: Having a tenant in the building helps make the fix up a repair.

Planning note 2: Spending more on repairs than on improvements helps keep the repairs classed as repairs. When improvements cost more than repairs, the IRS might succeed in saying that the repairs were simply part of the larger improvement plan.

Planning note 3: The word "new" signals improvement and not replacement or repair.

Six Good Strategies That Build Your Case

Is it a repair? Is it an improvement? Remember, most money spent to fix up property does not fall at a polar end of the repair or improvement scale. Often, two can spend the same money doing the same fix up and obtain totally different tax results. It is a question of facts, and how you present and establish your facts.

In its Internal Revenue Manual, the IRS says that the repair versus improvement question is a difficult issue. The issue requires auditors to make a thorough analysis and maximum use of judgment to interpret the rules.

Strategies for repairs to your rental and business properties: If you own rental or business property, follow the six strategies below to produce deductible repairs. If you are not fixing up your personal home, do not follow the six strategies (violate every one you can) so that you can call fix ups improvements.

  • Segregate repairs from improvements
  • Fix minor portions only
  • Use similar, comparable, or less expensive materials
  • Fix damages only
  • Repair after events
  • Repair during occupancy and between tenants.
1. Segregate repairs from improvements: If you are going to renovate the place, but also make certain repairs, you must segregate the repairs from the improvements to deduct the repairs. The IRS, in its audit manual, says that repairs are not repairs but improvements when made as part of a general overhaul of the building. Thus, make sure that the repairs are not part of an overall plan and, if possible, have repairs done by a different contractor.

2. Fix minor portions only: You make an improvement when you replace an entire wall, roof, or floor. If you repair only a portion of the wall, roof, or floor, you are making repairs.

3. Use similar, comparable, or less expensive materials: If your purpose is to restore to sound state or mend, you should use comparable materials. If your purpose is to improve, you should use better quality or improved materials.

4. Fix damages only: If you repair, you replace or restore worn out, broken, and deteriorated parts of the property. When you expand your repair to portions of the property, not work out, broken, or deteriorated, you make an improvement.

5. Repair after events: Generally, you think out an improvement before you begin to make the improvement. With a repair, something happens that calls your attention to the need for the fix up. A broken water pipe requires repair. Wear and tear produces a need to repaint.

6. Repair during occupancy or between tenants: In its audit manual, the IRS suspects that you might buy a property, renovate it, and then try to expense the costs are repairs. The IRS tells its agents to watch for people like you and propose adjustments. Avoid scrutiny! Wait! Own the property for a time before making repairs! Have tenants in place when you make repairs!

Strategies for improvements to your home: If you are fixing up your personal home, do not follow the six strategies above. Instead, violate every one you can! With proper violations (called planning), you can call fix ups improvements. Here is a summary of steps to make fix ups improvements:

  • Combine repairs with overall plan for home improvement
  • Fix minor portions of home as part of overall plan
  • Use "new," better, or more expensive materials to improve the home
  • Fix both good and damaged areas of the home
  • Do not associate the improvement with an event
  • If practical, go on vacation or move out during big improvements
Reminder: Improve the home! Repair rentals and business properties!

Farmer's Creamery Case

Water seepage rotted the floor and walls of the building. The Company spent big dollars repairing the property. Because repair costs were high, the IRS wanted to classify the fix ups as improvements. The Court said that the fix ups were repairs because:

  • The Company made the repairs for sanitary purposes, safety, and continued use of the building.
  • The Company continued to use the building during the repairs.
  • The repairs were not part of an overall improvement plan.
  • The expenditures did not require a building permit.
  • Materials used to make the repairs were similar to materials replaced.
  • The repairs did not enlarge or change the building design.
  • The fix up did not appreciable prolong the building's useful life.
  • The Company properly classed the fix ups as repairs in the Company's books of account.
  • It appeared that the Company fixed only the deteriorated parts.
  • The Company replaced less than one-half of any wall, ceiling, or floor.
Keep the right records: You know you need receipts. Keep more than receipts! Document events that precede repairs and note the nature of fix ups in your log book.

Other examples from the Courts

Think like a prosecuting attorney! Gather evidence to win your case. The definitions of repair and improvement give you room to maneuver. The amount spent does not make either a repair or an improvement. For example, repairs to a cotton gin typically cost about 80 percent or more of original cost -- the gin must be repaired after every cotton season.

To get maximum benefit, you want rental and business property fix ups classed as repairs. The courts provide hundreds of cases that clearly demonstrate the reason for the repairs. Take a moment and note the reasoning (cause and effect) that supports repairs in the following selected cases:

  • Timbers to support a sidewalk built over a basement
  • Copper sheeting to replace a cornice blown off by the wind
  • Straighten a roof alignment because of sinking subsoil
  • Resurface a damaged floor
  • Line walls and basement floors to prevent oil seepage
  • Tuck pointing and cleaning exterior walls of a brick building
  • Paint and white-wash walls and ceilings
  • Replaster and repaint
  • Patch a leaking roof
  • Shore-up the building foundation to prevent collapse
  • Replace an air-conditioning compressor
Note the cause that created the need for a repair. Try to link your fix up to a cause. With a cause, you have a great chance of calling the fix up a repair.

On the other hand, with improvements, you might have a plan, but never a cause. Note the common characteristics in the following improvements:

  • New doors for a building
  • New iron grills on windows
  • New fire escapes
  • Skylights
  • New oil-burning heating system replacement for coal-burner
  • Lower the basement floor to fit the basement to a new use
  • Replace the side wall and front of a building for a new look
  • Substitute one type of window for another
  • Construct a new floor
  • Rewire the building
Planning tip: The word "new" indicates improvement. If you want repairs, avoid "new." If you want improvements, look for "new."

Lawns and landscaping: Costs of landscaping, including planting of trees and shrubbery, around a new building are generally depreciable. In 1974, the IRS said depreciate the trees and shrubs adjacent to the building. In this ruling, the IRS said that you may not depreciate the trees and shrubs located away from the building. We should note that IRS guideline depreciation tables assign a 20-year class life to landscaping. The tables do not require that shrubs sit near the building nor do they require amortization over the life of the building.

Planning tip: Count all costs of getting the landscaping in place, including water, hoses, and fertilizer.

IRS Targets Fix Ups for Audit

The IRS tells its auditors to look for misclassifications in the repairs and improvements accounts. More specifically, the IRS tells its:

  • Business auditors to look in the repairs account for improvements improperly classified as repairs (adjustments produce fewer deductions for the taxpayer and more money for the IRS)
  • Personal-home auditors looking at home sales and tax-deferred rollovers to scan improvements for repairs improperly added to basis of personal homes (adjustments produce less basis and more tax for the government)
Protect yourself from an IRS audit! Document your deductions as you claim them.

Planning Rental Property Deductions

Rental properties are automatically passive investments and produce a number of complex (but often rewarding) scenarios. For example:

  • Real estate sales professionals are exempt from the passive loss rules and can use real estate rentals as tax shelters
  • Properties rented for periods of 7 days or less are not rental properties; instead, the 7-days-or-less rentals passive hotels if you do not materially participate in the properties.
  • If your property is a rental property and your modified adjusted gross income is between $100,000 and $150,000, you can deduct up to $25,000 of losses assuming you can actively participate in the property.
Many strategies besides those above ensure that you get maximum rental-property deductions. This article concerns only part of those deductions -- the repair. Later this year, we plan an article on how to deduct maximum rental property losses -- from repairs, travel, hiring the children, etc.

Summary

When it comes to repairs and improvements, it pays to know the rules. On rental and business property, the repair produces more than double the value of an improvement. On your personal home, the improvement is infinitely better than the repair (the repair is useless). Thus, before you make the repair or improvement, read this article. Then, plan your fix up for maximum tax benefit.


Disclaimer and Acknowledgment

From Murray Bradford's Tax Reduction Letter, 170 Reservoir Rd, San Rafael, CA 94901.

The information provided is deemed reliable but is not guaranteed. PLEASE consult your tax professional regarding your own circumstances.




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