In this second article in our series on real estate tax topics, I will discuss how to determine whether work performed on your real estate property is a repair or an improvement. The tax treatment for each is quite different, as discussed below.
Why it’s important
Many landlords complete work on their property under the assumption they can deduct these costs as they are incurred for tax purposes, and only later discover that this work is considered an improvement to the property, with the costs being deducted through depreciation expense over the life of the improvement. Therefore, it is important to understand how these costs are classified by the IRS.
Repairs versus improvements
Repairs made to your rental property are fully deductible in the year these costs are incurred, so long as these expenses are ordinary, necessary, and reasonable in amount. However, not all costs incurred for the upkeep of your rental property is classified as a repair for tax purposes. Instead, they may be classified as capital improvements. Capital improvements cannot be expensed immediately, and instead they are depreciated over several years. In fact, improvements to residential rental property must be depreciated over 27.5 years.
It is also important to note that some improvements, such as land improvements or improvements to personal property (i.e. new carpeting, appliances, etc.) are eligible for bonus depreciation (through 2025 under current tax law) can usually be deducted in one year by using bonus depreciation, section 179 depreciation, or the de minimis safe harbor. However, repairs are still the best option for classifying these costs, due to depreciation recapture requirements when the improved property is sold.
Unfortunately, the guidance provided in determining whether these costs are repairs or improvements is not always clear and straightforward. In 2014, the IRS issued a 222 page set of repair regulations. These regulations are a bit of a mixed bag for landlords. On the positive side, the IRS included three safe harbors that permit many landlords to deduct most or all of their expenses in the current year, regardless of whether they are classified as repairs or improvements. In addition, these regulations allow landlords to elect to take an immediate deductible loss when individual building components are replaced instead of having to continue to depreciate these components over the building’s remaining useful life.
Safe harbors
As mentioned above, the IRS included three safe harbors in the 2014 regulations. Below is a brief description of each of these safe harbors:
- Safe Harbor for Small Taxpayers (SHST) – This is the most important safe harbor for small landlords. If you qualify for this safe harbor, you may currently deduct all annual expenses for repairs, maintenance, improvements, and other similar costs as an operating expense on Schedule E. To qualify as a small taxpayer, you must meet the following criteria: 1) only applies to buildings that have an unadjusted basis (i.e. building’s original cost, less value of land, plus the cost of any improvements) of $1 million or less; note that if you own more than one building, the $1 million limit is applied to each building separately; and 2) the SHST safe harbor can only be used if the total amount paid during the year for repairs, maintenance, improvements, and similar expenses for a single building does not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. This safe harbor must be claimed by filing an election with your tax return.
- Routine Maintenance Safe Harbor – Routine maintenance is recurring work that is performed in order to keep a building, and all of its component systems, in good working order. Routine maintenance includes both a) inspection, cleaning, and testing of the building structure and/or each building system, and b) replacement of damaged or worn parts with comparable and commercially available replacement parts. The costs of performing routine maintenance is expensed when incurred. However, there are two key limitations on this rule: 1) Ten Year Rule – Building maintenance qualifies for this safe harbor only if, when placed in service, the owner reasonably expected to perform this maintenance more than once every 10 years, and 2) No Betterments or Restorations – this safe harbor is intended only for expenses incurred by property owners to keep their property in ordinarily efficient operating condition.
- De Minimis Safe Harbor – This safe harbor is used by landlords to currently deduct low-cost items used in their rental business, regardless of whether or not the item would constitute a repair or improvement under the regular repair regulations. It can be used for personal property and building components that comes within the deduction ceiling, and for most landlords this maximum amount is $2,500. This safe harbor must be claimed by filing an election with your tax return. You must also formally adopt (in writing) an accounting policy that requires the expensing of these items. Similar to the Routine Maintenance Safe Harbor, all expenses deducted using this safe harbor must be counted toward the annual limit for using the safe harbor for small taxpayers (i.e. lesser of 2% of the rental’s cost or $10,000).
Classifying repairs vs. improvements when safe harbors do not appy
If a landlord is unable to take advantage of these three safe harbors, then a determination must be made for each expenditure whether it is appropriately classified as a repair or as an improvement. The first steps in determining this classification is to do the following:
- determine the unit of property involved (UOP), and
- decide whether the expense involved resulted in an improvement or repair.
Defining the UOP is crucial, as the larger the UOP, the more likely work done on a component will be considered a repair versus an improvement. According the IRS regulations, each building must be divided into as many as nine different UOPs, as follows:
- UOP #1 – The Building Structure
- UOP #2 – Heating, Ventilation, and Air Conditioning (HVAC) System
- UOP #3 – Plumbing System
- UOP #4 – Electrical System
- UOP #5 – Escalators
- UOP #6 – Elevators
- UOP #7 – Fire Protection and Alarm System
- UOP #8 – Security System
- UOP #9 – Gas Distribution System
Under the IRS regulations, a UOP is improved whenever it undergoes a betterment, adaptation, or restoration. The regulations to define these are rather vague, and therefore this determination must be made based on the facts and circumstances of each individual case, including the purpose and nature of the work performed and its effect on the UOP. Repairs typically cost less than improvements, however under IRS regulations quite large expenditures can qualify as repairs, depending on the nature and extent of the change to the UOP.
“Repairs” made before property placed in service
As a landlord, it is critical to understand that the timing of repairs can be of critical importance in determining the deductibility of these costs. If repairs are made prior to the property being “placed in service,” these repairs cannot be immediately expensed, and in fact must be added to your property’s cost basis and depreciated over the life of the property (i.e. 27.5 years in the case of residential rental property). A property is considered to be placed in service on the date that your offer it for lease. Therefore, you may want to hold off on any expenditures for repairs until you have listed the property for rent. This may save you a lot of money when you file your taxes.
Key definitions
As stated above, improvements are defined as a property that undergoes a betterment, adaptation, or restoration. Below are the IRS definitions of each of these terms:
- Betterment – An expenditure is considered a Betterment if it a) ameliorates a “material condition or defect” in the UOP that existed before it was acquired; b) is for a “material addition” to the UOP (i.e. physically enlarges, expands, or extends the property, or adds a new component); c) is for a material increase in the capacity of the UOP; or d) is reasonably expected to materially increase the productivity, efficiency, strength, or quality of the UOP or its output.
- Restoration – An expenditure is a Restoration if it a) replaces a major component or a substantial structural part of a UOP; b) rebuilds the UOP to like-new condition after it has fallen into disrepair; c) replaces a component of a UOP and deducts a loss for that component (other than a casualty loss); d) replaces a component of a UOP and realized a gain or loss by selling or exchanging the component; e) restores damage to a UOP caused by a casualty event and makes a basis adjustment to the UOP; or f) rebuilds a UOP to like-new condition after the end of its IRS class life.
- Adaptation – An expenditure is considered an Adaptation if the work performed creates a new or different use for that asset. A use is “new” or “different” if it is not consistent with the intended ordinary use of the UOP when it was originally placed in service. Adaptations are somewhat rare in residential rental real estate. One example would be the conversion of an old factory building into loft apartments.
As you can see, classifying expenditures as repairs or improvements can be quite complex, so speak to your tax advisor to get help in classifying these expenditures correctly. I also strongly suggest that you keep clear, thorough, and easy to understand documentation of these expenditures. If your deductions are ever challenged by the IRS, your success or failure in responding to these inquiries will likely depend on how well you have documented these transactions. Below are just a few tips related to good documentation for property repairs:
- Many repairs are triggered by tenant complaints. Have in place a process to document these complaints and requests, such as a calendar, appointment book, or the repairman’s invoice. Make sure you document any items that are broken and that it was fixed.
- Always get an invoice for every repair that is made. It should accurately describe the work in a way that is consistent with the definition of a repair, not an improvement. Some good words to use include repair, fix, patch, mend, redo, recondition, restore, etc. Avoid words that would indicate the work is an improvement, such as improvement, replacement, remodel, renovation, addition, construction, rehab, upgrade, or new.
- Make sure your accounting records are aligned with the nature of the work performed. Make sure your bookkeeper properly records repairs in the repair expense account and improvements are recorded in the correct improvements asset account.
- For extensive, costly repairs, consider taking before and after photographs that show the extent of the work. This will provide visible proof that the property has not been made significantly more valuable by performing the work.
If you are a landlord and find yourself needing a CPA with expertise in real estate matters, please reach out to us. We would be glad to help you navigate these complex issues! I can be reached by phone at (479) 876-9980, ext. 102, or by email at Brent@seaycpas.com.