As landlords enter transactions into QuickBooks, they must decide if something is an expense or a capital improvement. The impact is significant.
Example: You have a property that will earn $12,000 in gross rent this year (and $5,000 after insurance, property taxes, depreciation, etc). You bought if Jan. 1st this year for $100,000. You expect to pay taxes on the $5,000 in income.
The purchase price is generally capitalizable (some exceptions are if it was already rented and in the $100K you also received cash for the current tenant’s security deposit. Then you’d need to transfer the security deposit.) What if you need to put on a $3,000 new front porch and replace the carpet in the living room for $450? You’ll spend the money, but how do you record it in QuickBooks?
Let’s say you expense everything.
Your expected $5,000 in income is reduced to $1,550. “Great!” you may say, you pay less in taxes, because all repairs can be deducted from income in the current year. Your balance statement will not change, only your income statement. Is this correct? Is this legal?
Let’s say you capitalize everything.
You will still earn almost $5,000. You will have a more valuable asset on your balance statement, and you will have a little bit more depreciation to offset income (which is why you will be taxed on a bit less than $5,000). “Terrible!” you say, you pay more taxes and have to wait for years for depreciation to offset income which could have happened all at once if you only expensed it. Is this correct?
The problem here is capital improvements must be depreciated. The problem with depreciation is you do not get to make a full deduction to your income in the year the payment was made.
What is the right way?Generally speaking you do not have a say in what you can expense and what you must capitalize. The tax authorities have pretty clear guidelines. Everyone in the US should at least skim Pub 527 Residential Rental Property. You still get to deduct capital improvements from income to lower taxes, but they must be spread out over the particular asset’s depreciation schedule. The IRS explains you capitalize what “extends the useful life” of the property. Examples of capital improvements:
- replacing a roof
- building an addition or a garage
- replacing all plumbing, electric, or windows
- fixing a bad patch of a roof
- repainting a room
- replacing bad flooring
What’s a smart landlord to do?
Skim Pub 527, but don’t stop there and try to do everything yourself. Many tax strategies have been tested in court and you need to find an accountant that can help you be aggressive, but entirely in compliance with what courts ruled and the IRS requires.
For instance, you may find some tax lawyers will advise you to expense most of the costs spent to bring a rental up to service, even if these would normally be capitalized in a very strict reading of the tax law. He or she will have very specific reporting requirements for you, fortunately these are quite easy when you set up QuickBooks correctly and have an organized office.
If you must depreciate, and you are operating a profitable company, then you can optimize current year’s deductions by using an accelerated depreciation schedule instead of a straight-line schedule.
The verdict? Set a goal this year to meet several new accountants and ask them about how they optimize taxes for other landlords. First meetings will be free, and you will be able to ask lots of questions and find someone who can help you find a legal balance between capitalizing and expensing your outflows.
Want more? Read our blog for other articles (like this one previewed from the training guide) or go ahead and buy the full course right now to learn how to use QuickBooks for Landlords and Property Managers. (We have lots of screenshots of how to enter expenses and capitalized transactions.)
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