Many Texas real estate investors make repairs, updates, and improvements to enhance a property in preparation for listing it with a real estate broker. Investors relinquishing the property in a 1031 like-kind exchange often ask if they can be reimbursed from the 1031 exchange for the costs associated with improving or repairing the property immediately before the sale.
The answer is no—not without generating a tax consequence. The reason is that any proceeds—whether money or benefits of any kind or property that is not “like-kind” that an investor receives from a 1031 exchange—are known as “boot” and are generally taxable to the extent the investor has a capital gain tax consequence.
However, improvements an investor makes to a relinquished property can be added to the cost basis of the property. In simple terms, the cost basis is the amount a property is worth for tax purposes. The cost basis changes over time and becomes known as the adjusted basis. The adjusted basis can be increased by adding capital improvements made to the property. The adjusted basis also can be reduced by factors such as depreciation deductions taken annually on tax returns during the ownership period.
Generally, the cost of making capital improvements with a useful life of more than one year is added to the adjusted cost basis. This is referred to as a capital expense and must be capitalized and depreciated over multiple years. An improvement includes enhancements that add value to the property, increases its useful life, or adapts the property to a new use. Capital improvements can include room additions, new bathrooms, new roofs, decks, fencing, wiring upgrades, driveways, walkways, plumbing upgrades, and kitchen upgrades. The IRS uses the following categories to define a capital expense, which must be depreciated:
- Improvements: A taxpayer must capitalize any expense made to improve an investment property. An expense is for an improvement if it results in a betterment to the property, restores the property, or adapts the property to a new or different use.
- Betterments: Expenses for fixing a pre-existing defect or condition, enlarging or expanding the property, or increasing the capacity, strength, or quality of the property.
- Restoration: Expenses for replacing a substantial structural part of a property, repairing damage to a property as a result of a casualty loss, or rebuilding the property to a like-new condition.
- Adaptation: Expenses for altering the property to a use that is not consistent with the intended ordinary use of the property when initially purchased or held for investment.
Conversely, costs that can be deducted as current expenses are amounts paid for incidental repairs and routine maintenance. These costs are not added to the adjusted cost basis. Repairs are usually one-off fixes or repairs that help keep the property in good working condition and habitable. A real estate investor can deduct the cost of minor repairs from the current year’s tax liability. However, the cost of minor repairs does not reduce the investor’s capital gain tax liability to the extent they have a capital gain. The IRS clarifies in the 1040 Schedule E Instructions that “repairs in most cases do not add significant value to the property or extend its life.” Real estate investors in Texas can find more information on basis and adjusted cost basis in IRS Publication 551, Basis of Assets.
A 1031 exchange is an excellent tax deferral option for Texas real estate investors who want to dispose of one property held for investment and invest in another like-kind replacement property also held for investment. Knowing how improvement costs factor into the transaction and whether those costs will be taxed is essential when assessing the merits of a real estate transaction. As always, investors should seek the advice of a tax advisor regarding the unique facts and circumstances of their specific transaction.