How to Depreciate Improvements on Rental Properties

While rental property improvements are sometimes costly, experienced property owners know it’s worth every penny spent. Not only do they enhance the property's value, but they also offer various tax benefits that you may not have previously considered.

However, it's important to understand that improvements go beyond simple tasks like painting walls or fixing leaky faucets. They involve strategic investments designed to attract tenants while aligning with sound financial planning through depreciation. This allows you to recover costs over time and reduce your taxable rental income.

This article will clarify what depreciation of rental property improvements entails and how it functions, serving as a comprehensive guide to maximizing the potential of your real estate investment.

What Qualifies as a Rental Property Improvement?

To begin, it’s crucial to distinguish between repairs and improvements, as each carries significant tax and financial implications.

Repairs vs. Improvements

Repairs are actions taken to maintain the property’s current condition. They ensure that everything operates smoothly, keeping the property habitable and appealing to tenants. 

Examples include fixing a leaky faucet, patching a hole in the wall, or replacing a broken window. The primary purpose of repairs is maintenance rather than enhancing value or extending the property's useful life. 

In contrast, improvements are investments that can increase your property’s value, extend its lifespan, or adapt it for new uses. These are typically more substantial than simple repairs. 

According to IRS guidelines, improvements encompass betterments, restorations, and adaptations made to the property—ranging from installing a new roof to upgrading the HVAC system or remodeling the kitchen.

Repairs and maintenance are immediately tax deductible in the year they occur, whereas you cannot deduct improvement costs in a single tax year as you can with repairs; improvement costs must be added to the property cost basis and depreciated over their ‘useful life’, providing an extended tax benefit.

Read more: Capital Improvements vs. Repairs and Maintenance

Common Rental Property Improvements

Here are some common improvements that can enhance your rental property's value:

• Roof Replacement: Replacing an old or damaged roof prevents potential water damage and mold growth while significantly improving insulation. This can lead to lower heating and cooling costs—an attractive feature for eco-conscious tenants looking to minimize utility expenses.
• HVAC System Upgrade: Installing a modern, high-efficiency HVAC system can greatly reduce energy consumption and lower utility bills, appealing to many tenants concerned about their carbon footprint. Beyond immediate benefits like improved air quality and comfort, an upgraded HVAC system can justify higher rental prices.
• Room Addition or Extension: Expanding your rental property with an additional room or extension increases square footage and potentially boosts rental income. For example, transforming a cozy two-bedroom home into a three-bedroom dwelling can attract families seeking extra living space.
• Kitchen Remodel: Kitchens often serve as the heart of a home; thus, a well-planned remodel can significantly influence prospective tenants' decisions. Consider features like stainless steel appliances, granite countertops, and efficient storage solutions to enhance both aesthetics and functionality.
• Landscaping Improvements: While new sprinkler systems or major alterations may not directly extend a building's life, they can enhance overall property value and curb appeal. However, IRS regulations regarding landscaping depreciation can be complex due to varying useful life expectations.

Understanding Depreciation of Improvements

Depreciation allows you to spread the cost of an improvement over its useful life through tax deductions over several years. This process helps manage your tax liabilities more effectively while accounting for wear and tear on the property.

General Rules for Depreciating Improvements

Recovery Periods

The IRS has established specific recovery periods for various types of property improvements. For most residential rental property improvements, depreciation occurs over 27.5 years under the Modified Accelerated Cost Recovery System (MACRS). This system enables you to recover your investment cost more rapidly than the actual expected lifespan of the property.

Depreciation Methods

Landlords have two primary methods for depreciating rental property improvements under the General Depreciation System (GDS):

• 150% Declining Balance Method: This accelerated method allows for larger deductions in the early years of an improvement’s life, with amounts decreasing over time. It applies a consistent rate of 150% of the straight-line depreciation rate.
• Straight-Line Method: This approach distributes the improvement’s cost evenly across its useful life, providing a consistent deduction each year at an annual rate of 3.636% if the improvement falls within a 27.5-year category. This method is straightforward and predictable, making it appealing for investors seeking simplicity in their depreciation expenses.

Starting Point for Depreciation

Depreciation begins when the improvement is placed in service—meaning it is ready and available for use in your rental—not necessarily when it is completed. Even if an improvement is finished late in the year, you can start depreciating it as soon as it is in service.

Related Article: Understanding Rental Property Depreciation and Depreciation Recapture

Steps to Begin Depreciating Your Rental Property Improvements

Using a kitchen remodel as an example, here are steps to start depreciating an improvement:

Determine the Improvement’s Depreciable Basis

Identify the total depreciable basis of your improvement—not just direct costs like materials and labor but also associated expenses such as permits and architect fees. For example, your kitchen remodel costs $20,000 in total.

Choose the Correct Depreciation Method and Recovery Period

While many opt for the straight-line method for residential properties due to its simplicity—providing equal depreciation expense each year—you still need to identify the associated recovery period for the improvement type. 

The general recovery period for structural components is 27.5 years; however, items within a remodel (like appliances) may have shorter useful lives.

Calculate Annual Depreciation Expense

When using the straight-line method, identify items eligible for shorter depreciation periods (cost segregation). 

Continuing with our $20,000 kitchen remodel example: 

If $5,000 was spent on appliances with a 5-year life expectancy, you could depreciate those at $1,000 annually ($5,000 / 5). The remaining $15,000 would depreciate over 27.5 years at approximately $545.45 annually ($15,000 / 27.5).

In total for five years, you could deduct $1,545.45 ($1,000 for appliances + $545.45 for structural improvements) from your taxable income until the appliances are fully depreciated; thereafter, only $545.45 would remain unless further improvements were made.

By separating these elements effectively, you can accelerate your depreciation strategy and enhance your short-term tax benefits while complying with IRS regulations.

This is a simplified example, but, as you can probably tell, calculating depreciation can become very complex, and to maximize your deductions upfront, you could end up managing multiple depreciation schedules. To ensure you are managing depreciation correctly and maximizing your deductions, make sure to speak with a tax specialist or CPA.

Reporting Depreciation on IRS Form 4562

To report your depreciation expenses accurately, use IRS Form 4562: Depreciation and Amortization. This form details your improvement costs, service dates, and calculated annual depreciation expenses—ensuring compliance with IRS regulations while maximizing available deductions.

Special Considerations and Tips

Depreciating rental property improvements involves more than following standard procedures; several unique scenarios could significantly impact your tax situation:

• Improvements Made Shortly After Purchase: These costs might be bundled into the property's overall basis instead of treated as separate depreciable expenses; consulting with a tax professional is advisable for proper categorization.
• Section 179 Deductions: Although often associated with business equipment, certain property improvements may qualify for immediate expensing under Section 179 instead of being depreciated over several years—this includes items like security systems or HVAC upgrades.
• Bonus Depreciation: Unlike Section 179 deductions, which have caps on qualifying amounts, bonus depreciation applies to both new and used properties without limits on total deductions. The Tax Cuts and Jobs Act expanded bonus depreciation to 100% for qualified properties placed in service after September 27, 2017—and before January 1, 2023—but this percentage will phase out by 2026 unless extended by Congress.

Common Mistakes to Avoid

Here are some of the common mistakes landlords and property owners make when depreciating rental property improvements. This knowledge would help you avoid them and maximize your rental property improvement depreciation benefits. 

• Misclassifying Repairs as Improvements: Repairs maintain property upkeep and allow full deduction in their year; improvements add value or prolong life and must be depreciated.
• Incorrectly Calculating Depreciation: Errors may arise from using incorrect bases or methods or mishandling partial years.
• Neglecting Updates When Making Additional Improvements: Adjust calculations accordingly if further improvements occur during depreciation periods.
• Overlooking Bonus Depreciation and Section 179 Deductions: Many landlords miss opportunities here due to a lack of awareness about qualifying conditions.
• Failing to Depreciate Improvements Altogether: Some owners neglect this due to oversight or insufficient knowledge.
• Inadequate Record-Keeping: Detailed documentation is vital for supporting claims; insufficient records can complicate defense during IRS audits.

Streamlining Depreciation with Landlord Studio

Managing the depreciation of rental property improvements can be complex, but integrating a tool like Landlord Studio can simplify the process and enhance your financial management. Landlord Studio provides landlords with a user-friendly platform to track expenses, categorize costs, and ensure compliance with IRS regulations.

With Landlord Studio, you can:

• Accurately Track Improvement Costs – Record every expense related to property improvements, from materials and labor to permits and professional fees, ensuring you establish a clear depreciable basis.
• Differentiate Between Repairs and Improvements – Properly categorize expenses and separate capital expenses from deductible operating expenses to avoid misclassification errors that could impact your tax deductions.
• Generate Detailed Financial Reports – Access easy-to-use reporting tools that provide an overview of expenses, helping you work with your accountant to calculate depreciation accurately.
• Stay Organized with Documentation – Keep receipts, invoices, and records securely stored in one place to simplify tax filing and support your deductions in case of an audit.

By leveraging Landlord Studio’s financial management features, landlords can maintain accurate records and streamline tax preparation. 

Create your free Landlord Studio account today to take control of your rental property finances.

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