Oregon Tax Consultants Practice Exam

If you improve a rental property significantly, how should you handle that cost?

1. Deduct it as a business expense

2. Add it to the basis of the property

3. Report it as an increase in income

4. Ignore it for tax purposes

The correct answer is: Add it to the basis of the property

When you make significant improvements to a rental property, the appropriate way to handle those costs is to add them to the basis of the property. This is because significant improvements enhance the value of the property, prolong its useful life, or adapt it to a different use, thereby meeting the criteria for capitalization. By increasing the basis, you are effectively accounting for the investment you made in the property. This can be beneficial later when the property is sold, as a higher basis reduces the amount of taxable gain on sale, potentially lowering tax liability. Additionally, by adding these costs to the basis, you align with the tax rules that govern asset capitalization versus expensing. Other approaches, such as deducting it as a business expense, would typically apply to regular maintenance or repairs, which do not materially change the property’s value or extend its life. Reporting the costs as an increase in income or ignoring them entirely would not be consistent with tax regulations and could lead to inaccurate reporting on your tax return. Thus, adding significant improvement costs to the basis of the rental property is the correct and beneficial method for handling such expenditures.