PARAMOUNT MORTGAGE - LENDER'S BLOG

The Internal Revenue Service (IRS) has “issued a massive new set of regulations, with complex rules, in 2012” that will affect the profitability of owning rental and investment properties says Stephen Fishman, a tax expert, attorney and author.

Some of these new rules change the definition of what constitutes a deductible repair versus an improvement.

“The regulations will likely make it more difficult to classify fix-ups and other building expenses as currently deductible repairs,” states Fishman. “When it comes to taxes, repairs are far more valuable than improvements, up to 271 percent more valuable.” There are two big reasons why:

1.)  Repairs are currently deductible in a single year, while improvements must be depreciated over many years (39 years for nonresidential buildings, 27.5 years for residential buildings);

2.)  If you sell a building at a gain, you must pay a recapture tax of up to 25 percent on the depreciation you claimed in prior years.

So what's the difference between a repair and an improvement? An improvement is a major change or alteration to property. The IRS says there are three types of improvements:

betterments – improving property or repairing defects;
restorations – making older property like new and;
adaptations – adapting property to a new use.

In contrast, a repair doesn't make a property better, restore it, or adapt it to a new use. A repair is a minor change that just keeps property in good running order.

The IRS now says that fixing your roof, replacing heating and air conditioning systems, installing plumbing or electrical systems, even if relatively minor in scope, will be classified as improvements rather than repairs.

Add to this list fire-protection and alarm systems, security systems, gas distribution systems, elevators and escalators. Now, under new IRS rules, a property owner cannot “repair” these systems, he or she can only “improve” them.

Fishman says, “The new regulations require that buildings be divided up into as many as nine separate properties for tax purposes: the entire structure and up to eight separate building systems.

A significant change to any of these systems must be treated as an improvement and depreciated over several years. As a result, more costs will have to be classified as improvements rather than repairs.

If you own rental or business property, or if you should become an “accidental landlord” in 2012 by electing to rent your home rather than sell it at a loss, you should talk with your tax adviser about how these new regulations will affect you.