We are going to convert our home into two units and rent it out. Can renovation expenses be tax deductable?

Question: Unfortunately, because the bottom fell out of the real estate market, we’re underwater on our mortgage and can’t sell our home. Instead, we’re thinking of renting it out. The house has a mother-in-law suite which we’re going to finish as a separate apartment with its own entrance so we can have two different tenants. What expenses can we deduct? In particular, can we deduct the cost of renovating the mother-in-law suite into a separate apartment?

Response: Good news and bad news. First, renting real estate is like any other business—you have to pay taxes on the profit you make. Since profit is revenue or receipts (what you take in) less expenses, you can deduct the ordinary costs of having and managing a rental from your income tax. Those expenses include:

• Mortgage interest
• Property tax
• Operating expenses (e.g. advertising or marketing the real estate; utilities; insurance; any one you hire to help oversee or manage the rental, even on a part-time basis)
• Repairs (maintenance, such as painting; replacing broken doors, locks, or windows; fixing leaks and electric problems; etc.)

However, you may not deduct the cost of renovating your home to have a separate apartment. That’s because that’s an “improvement,” not “maintenance”—instead of just maintaining the current value of the building, an improvement actually adds to the value. Adding an apartment is a very clear improvement; other improvements include adding a fence, patio, or deck; replacing windows with energy efficient ones; adding central air; or putting on a new roof. You can recover the cost over a period of time—often a long period of time—through depreciation. Basically, any improvement is assumed to have a serviceable lifetime; each year during that life time, a pro rate share of its cost may be deducted. This lets you get a tax benefit, but usually spread out over years. Use Form 4562 to report depreciation.

Answered by Steven Zweig

Additional Resource: rental real estate income deductions - IRS.gov

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