Improvements to a rental property benefit you in multiple ways. In addition to increasing value, they offer several tax benefits you may not have considered previously.

However, an improvement is more than slapping a fresh coat of paint on the walls or fixing a leaky faucet. Making improvements is about investing in strategic work that appeals to tenants and aligns with smart financial planning through depreciation, allowing you to recover the cost over time while reducing your taxable net income.

This article explains what rental property improvements depreciation is and how it works, providing a clear guide to leveraging your real estate investment to its fullest potential.

What are considered rental property improvements?

First, differentiating between repairs and improvements to a rental property is essential because each has significant tax and financial implications.

Repairs are typically actions taken to maintain the current condition of the property. Think of them as the tasks required to keep everything running smoothly so your property remains habitable and attractive to tenants.

Examples of repairs include fixing a leaky faucet, patching a hole in the wall, or replacing a broken window. The key characteristic of repairs is that their primary purpose is to maintain your property rather than enhance its value or prolong its useful life.

On the flip side, improvements are investments that can increase your property’s value, extend its life, or adapt it for a new use. These are typically much more substantial than mere fixes.

Under IRS rules, improvements include betterments, restorations, and adaptations that are made to the property. That could mean anything from adding a new roof to upgrading the HVAC system or remodeling the kitchen.

However, you can’t write these improvement costs off in one tax year like you can with repairs. Instead, they must be depreciated over time, offering an extended tax benefit.

The basics of depreciating improvements

Depreciation allows you to distribute the cost of the improvement across its useful life through a tax deduction over several years. This process helps manage your tax liabilities more efficiently and reflects the wear and tear of the property improvement over time.

General rules for depreciating improvements

Recovery periods

The IRS has set specific recovery periods for different types of property improvements. Depreciation for many residential rental property improvements must occur over 27.5 years, following the Modified Accelerated Cost Recovery System (MACRS). This system is designed to recover the cost of your investment in a shorter time frame than the actual expected life of the property.

Depreciation methods

Under the General Depreciation System (GDS), landlords can choose from two primary methods for depreciating their rental property improvements:

• 150% declining balance method: This accelerated depreciation method allows for larger deductions in the early years of an improvement’s life, decreasing over time. It uses a consistent amount of 150% of the straight-line depreciation rate.
• Straight-line method: This approach spreads the improvement’s cost evenly across its useful life, offering a regular deduction amount every year at an annual rate of 3.636% if the improvement falls into a category with a useful life of 27.5 years. This method is straightforward and predictable, making it a preferred choice for investors seeking simplicity and stability in their depreciation expenses.

Starting point

Depreciation starts when the improvement is placed in service, when it’s ready and available for use in your rental, not necessarily when it’s completed. Even if an improvement is made late in the year, you can apply depreciation as soon as it’s in service.

Common rental property improvements

• Roof replacement: Replacing an old or damaged roof prevents potential water damage and mold growth and significantly improves insulation. This can lead to lower heating and cooling costs, a factor increasingly important to environmentally conscious tenants and those looking to minimize their utility expenses.
• HVAC system: A modern, high-efficiency HVAC system can greatly reduce energy consumption, lower utility bills, and has the potential to leave a smaller carbon footprint, which also appeals to many tenants. Along with the immediate benefits of improved air quality and comfort, an updated HVAC system can be a strong selling point, potentially allowing you to command a higher rental price.
• Adding a room or extension: Enlarging your rental property with a room or an extension means increased square footage, potentially boosting your rental income. For instance, you can transform a cozy two-bedroom home into a more versatile three-bedroom dwelling, attracting families who desire that additional living area.
• Kitchen remodel: Kitchens are often the heart of a home, and a thoughtful remodel can influence a prospective tenant’s decision, allowing you to command a premium on rent. Consider a remodel that includes stainless steel appliances, granite countertops, and efficient storage solutions to enhance the home’s overall look and functionality.
• Landscaping improvements: While a new sprinkler system or significant alterations to the grounds may not directly extend a building’s life, it can improve a property’s overall value and curb appeal. However, IRS regulations on depreciating landscaping improvements can be complex as some may have different useful life expectations.

How to begin depreciating your rental property improvements

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

1. Determine the improvement’s depreciable basis

The first step is identifying the depreciable basis of your improvement. This isn’t just about the direct costs of materials and labor. It also encompasses any associated expenses, such as permits and architect fees. For our scenario, imagine the total cost for the kitchen remodel is $20,000.

2. Choose the correct depreciation method and recovery period

While the straight-line method is a common approach for residential rental properties, offering an equal depreciation expense each year, it’s important to differentiate between the method and the recovery period.

The recovery period varies significantly based on the type of improvement. For instance, the general recovery period for the structural part of a building is 27.5 years. However, many items within a remodel, such as kitchen appliances, fences, or landscaping features, don’t align with this timeline due to their shorter useful lives.

3. Calculate the annual depreciation expense

When calculating the annual depreciation expense using the straight-line method, you’ll want to separately identify items that can be depreciated over shorter periods, also known as cost segregation.

Continuing with our $20,000 kitchen remodel example:

• If $5,000 of that cost was for new appliances with a 5-year life expectancy, you could depreciate those items at a faster rate. For the appliances alone, the annual depreciation expense would be: $5,000 / 5 = $1,000

• The remaining $15,000 for improvements with longer useful lives would continue to depreciate over the standard 27.5 years, resulting in the following depreciation expense: $15,000 / 27.5 = $545.45

In our example, you can deduct $1,545.45 ($1,000 for appliances + $545.45 for structural improvements) from your taxable net income for the next five years, until the appliances are fully depreciated. After that, your annual depreciation expense for the kitchen remodel would decrease to $545.45, assuming no other improvements were made.

By separating these elements, you can accelerate your depreciation strategy, generating more substantial tax benefits in the short term. Doing so aligns with IRS regulations and also helps to improve your property’s financial performance. 

Reporting depreciation on IRS Form 4562

To report your depreciation expenses, use IRS Form 4562: Depreciation and Amortization. This form is where you detail the cost of your improvement, the date it was placed in service, and the calculated annual depreciation expense. Filling out this form accurately is critical to ensure compliance with IRS regulations and take advantage of the depreciation deductions available.

Special considerations and tips

Depreciating your rental property improvements is more than following a standard process. Several special scenarios could significantly impact your tax situation.

Improvements made shortly after the property purchase

These costs can sometimes be bundled into the property’s overall basis rather than treated as separate depreciable expenses. However, consider consulting with a tax professional to categorize these expenses correctly.

Section 179 deductions

Most people associate Section 179 deductions with business equipment, but did you know certain property improvements can also qualify?

This powerful deduction allows you to immediately expense the cost of a qualifying improvement in the year it’s placed in service instead of depreciating it over several years. For rental property owners, this can include security systems, HVAC, and roofing, among others.

Bonus depreciation

Unlike Section 179, bonus depreciation can apply to new and used property and there’s no cap on the total amount you can deduct.

The Tax Cuts and Jobs Act expanded bonus depreciation to 100% for all qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023.

However, be mindful that the percentage for bonus depreciation is set to phase out entirely by the end of 2026 unless Congress votes to extend it.

Common mistakes to avoid

• Misclassifying repairs as improvements: Repairs are typically necessary for the property’s upkeep and can be fully deducted in the year they’re made. In contrast, improvements add value, prolong the property’s life, or adapt it to new uses and must be depreciated over time.
• Incorrect calculation of depreciation: Another common mistake is improperly calculating the depreciation expense. That could stem from using the wrong depreciable basis, selecting an incorrect depreciation method, not handling partial years properly, or applying the wrong recovery period.
• Failing to update depreciation when making additional improvements: If you make further improvements during the depreciation period, it’s crucial to adjust your calculations accordingly. Not accounting for additional improvements can result in under-depreciating your property and missing out on potential tax deductions.
• Overlooking bonus depreciation and Section 179 deductions: Many landlords miss out on claiming bonus depreciation or Section 179 deductions. These provisions can offer substantial upfront deductions for qualifying property but require that specific conditions be met.
• Neglecting to depreciate property improvements altogether: Surprisingly, some property owners don’t depreciate their property improvements at all, either from lack of knowledge or oversight.
• Failing to keep comprehensive records: Accurate and detailed record keeping is essential for supporting your depreciation claims. Inadequate documentation of improvements, costs, and service dates can make defending your depreciation deductions difficult if audited by the IRS.

How to easily track all your improvements and expenses

From understanding the difference between repairs and improvements to complex tax deductions like Section 179 and bonus depreciation, managing your property finances effectively is crucial for maximizing profitability and ensuring compliance.

To facilitate tracking your improvements and expenses, consider using Stessa, a platform designed to help landlords maximize returns and eliminate busy work. Stessa simplifies managing your improvement costs through features like automated bookkeeping, real-time portfolio insights, and tax-ready financial reporting.

With a comprehensive dashboard for monitoring key metrics and the ability to scan receipts and organize transactions on the go, Stessa enhances your rental business operations and improves tax efficiency by helping you maximize deductions.

You can also use Stessa to manage day-to-day operations like screening tenants, drafting leases, collecting rent, and staying organized with a high-yield bank account for each property.*

Go here to create a free Stessa account.

*Stessa is not a bank. Stessa is a financial technology company. Terms and conditions, features and pricing are subject to change. This article, and the Stessa Blog in general, is intended for informational and educational purposes only, and is not investment, tax, financial planning, financial, legal, or real estate advice.