RETAX: Repairs or Improvements?

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.

Potential Tax Changes by Congress

Congress is looking at multiple potential changes in the tax law in 2021. Nothing is certain yet, but here are some areas where they seem to be focused:

  • State and Local Income Tax (SALT) deduction – This itemized deduction item was capped a few years ago at $10,000. However, it appears congress is considering modifications to this limitation. Some of the ideas being discussed are raising it to $15,000, or possibly repealing the cap for taxpayers with income of $400,000 or less. This could be controversial, as these modifications would tend to benefit higher income taxpayers.
  • Moderate Tax Increases – There is apparently a few adjustments in tax rates being discussed. For example, there is discussion regarding raising the top individual rate from 37% to 39.6%. In addition, the top rate for capital gains could go from 20% to 28%.
  • Corporate Tax Rates – Congress is also considering raising the C-Corp tax rate from 21% to 25% while also having multinational corporations pay higher taxes.
  • Retirement Savings – See below.

Potential Changes to Retirement Savings

One area that has the potential for multiple changes is in retirement savings. Some of the ideas being debated by Congress are as follows:

  • Required Minimum Distributions (RMD) – Raising the age for requiring distributions from 72 to 75.
  • Enhancing tax benefits for small businesses that offer retirement plans.
  • Expansion of qualified charitable distributions.
  • For the catch-up contributions for employees 50 and older, there is some discussion regarding this coming from post-tax salary rather than pre-tax (i.e. no reduction in wages), in effect treating these contributions as a Roth IRA contribution. Although taxpayers would not get a tax benefit when the contribution is made, all earnings and most withdrawals in the future would be tax free.
  • Prohibit contributions to Roth IRAs with account balances greater than $5 million.
  • Other limitations to IRAs with significant balances.

Once again, nothing is certain, and it will depend on whether Congress can get enough support to get these passed into law. The debates and discussion are sure to heat up this fall, so we will be keeping an eye on these potential changes and keep you informed.

RETAX: Landlord Tax Classifications

Today I am starting a series of articles that I have titled RETAX, and where I will explore the most relevant tax issues that real estate owners face. The tax code as it relates to real estate is quite complex, so my goal is to broaden the understanding of these complex topics for those that own real estate. Today’s topic is a fundamental part of the tax code as it relates to real estate: Landlord Tax Classifications.

Tax Classifications

First, a point of clarification. In this article, the term “real estate owner” refers to those who own real estate for non-personal use purposes, renting the property to third parties and collecting rent. There are three tax classifications for real estate owners, as follows:

  • business owner
  • real estate investor
  • not-for-profit

It is the behavior of you as the owner that determines your tax classification. and this classification can have a significant impact on the taxes that you pay. Below I will provide you with an overview of each classification, from best to worst.

Business Owner

This classification is the best for the landlord, as it provides several tax deductions that are not otherwise available to real estate investors. These deductions include the following:

  • Home Office Expense – Do you use a space in your home that is dedicated to your work on rental properties? If the answer is yes, and you are classified as a business owner, you can take a deduction on your tax return for the expenses related to your home office. However, the rules for this deduction have some complexities, so you may want to seek the advice of a tax expert to make sure you qualify for this deduction.
  • Start-Up Expenses – Business owners are allowed to expense up to $10,000 in start-up expenses and $5,000 in organizational costs in the year the business is started. See IRS publication 583 for more details.
  • Section 179 – IRS code section 179 allows a business to expense certain equipment, furniture, and fixtures in the year acquired instead of depreciating these assets over their useful life.
  • Pass-Through Deduction – Businesses are allowed a tax deduction of up to 20% of their net rental income.

The key determining factor in determining whether you are a business owner rather than an investor is whether you, as landlord, are actively running a business. Therefore, to qualify as a business owner, you must be striving to earn a profit and work at it regularly and continuously. The IRS provides a list of factors that are to be considered in determining whether you are a business owner, as follows:

  • the type of rented property (i.e. commercial or residential)
  • the number of properties rented (although in certain cases one property has qualified as a business)
  • the owner’s (or owner’s agent’s) day-to-day involvement
  • the types and significance of any ancillary services provided under the lease
  • whether the landlord has filed all required information returns, such as form 1099-NEC

There is no minimum number of hours that have been set by either the IRS or the courts. However, the IRS has issued regulations that establish optional “safe harbor” rules that do establish minimum hours for landlords for certain situations, as follows:

  • 500 Hours – Net Investment Income Tax (NIIT) – As long as a real estate professional devotes a minimum of 501 hours each year to the rental property activity, this activity will qualify as a business for purposes of the NIIT, and the income will not be subject to NIIT.
  • 250 Hours – Pass-Through Deduction – The IRS assumes that the rental activity is a business for this deduction if the landlord spends at least 250 hours per year working on the rental activity.

Since these are safe harbor rules, a taxpayer can work less hours than this and still qualify as a business, depending on the specific circumstances. Also remember that these safe harbor rules are only to be used for these specific deductions, although if the taxpayer were to be audited, adhering to these would be a strong argument for overall qualification as a business.

Real Estate Investor

If you only own one or a few properties and you spend a minimal amount of time on them, then you are a real estate investor instead of an owner. There are a couple of situations that may make it more difficult for a landlord to qualify as a business owner, resulting in being classified as a real estate investor:

  • Your tenants are stable, your properties are well-maintained, and therefore there is little demand on your time to manage these properties.
  • You have commercial properties with triple-net leases, where the tenant is required to manage the property and pay the taxes.
  • You rent the property only to family and/or friends.
  • Your property is vacant for a significant amount of time.

Not-For-Profit

If you lack a profit motive for your real estate investments, the IRS may claim that you are a not-for-profit entity. Quite frankly, this is a tax disaster, as all of your revenues are taxable income, while you are not allowed any deductions to offset this income. So you should avoid this classification if at all possible. The easiest way to avoid this is to be profitable in your rental business.

There are three common situations where you are more likely to be at risk of being classified as not-for-profit, as follows:

  • You rent a vacation home that your family also uses
  • You rent your property at rates that are below the market
  • Your property sits vacant for long periods of time

Other than in these situations, it is not usually too difficult to prove you have a profit motive. There are two tests that the IRS uses to determine if there is a profit motive, as follows:

  • Three-of-Five Test – If you earn a profit from your rental activity in three of the past five years, the IRS presumes that you have a profit motive. However, if they discover you have manipulated the financial numbers to meet this test, then this could be (and likely will be) challenged.
  • Behavior Test – If you engage in your rental business primarily to earn profits, you may still have a profit motive even if you continually have losses. The IRS will look at several factors to determine if your behavior aligns with someone who wants to earn a profit, as follows: 1) how the activity is carried on; 2) your expertise; 3) the time and effort you spend; 4) your track record; 5) your history of income and losses; 6) your profits; 7) appreciation; 8) your personal wealth; and 9) elements of fun or recreation.

To pass the Behavior test, there are things you can do to support that you are seeking profit. This is especially critical if you have a history of losses on your rental properties. If this is the case (and even if it isn’t), following these steps are a good idea to keep you out of trouble with the IRS:

  • Keep good business records
  • Keep a separate checking account for your rental property business
  • Keep track of the time you spend working on your rental properties
  • Expend effort to rent your properties
  • Establish and document your expertise
  • Show evidence that you anticipate your property will appreciate in value
  • Prepare, maintain, and regularly update a business plan that shows how much you expect to earn over the time you expect to hold the property, including profits and cash flows

As these rules are quite complex, seeking a tax advisor who is up-to-date on these rules is a must for most real estate owners. At The Seay Firm, we specialize in the real estate and construction industries, so give us a call if you would like to set up an initial consultation. I can be reached at (479) 876-9980, ext. 102 or at Brent@seaycpas.com.

The Tax Consequences of NCAA’s NIL Rights

A monumental change is taking place for college athletes this summer, with many states having passed legislation to allow athletes to obtain financial income from selling their name, image, and likeness (NIL) to companies. With many states having laws taking affect this past week, the NCAA has now announced temporary rule changes to allow all athletes to take advantage of NIL. There will remain a lot of uncertainty and inconsistency until we get a federal law (being worked on), but one thing for certain is the IRS will be taking notice. I have yet to see any articles on the tax implications for these athletes and their families, so let me be one of the first to sound the alarm bells and encourage all athletes benefiting from NIL income to ensure you do not get sideways with the tax authorities.

Don’t mess with the IRS

Make no mistake, the IRS will see these new laws as a new source of income for the government, and athletes earning money while in college will now have to file taxes and report this income. If you do not comply, you will likely be subject to onerous penalties and interest for failure to file returns and pay your taxes. And my guess is most 18-22 year old’s do not have much experience filing taxes, as most likely did not make enough part time income to be required to file.

The types of income that these athletes will be making is similar to endorsement income made by professional athletes and other celebrities. And there are numerous examples of these more experienced, mature adults running afoul of the IRS because they did not file, or they did not properly report their income. Here are a few examples:

  • Ozzy and Sharon Osbourne – As of 2011 owed the IRS more than $2 million for unpaid taxes from 2007 – 2009. The IRS put a lien on their house.
  • Dionne Warwick – Filed for bankruptcy in 2014, stating she owed $10.7 million in federal and state taxes.
  • Pamela Anderson – Owed more than $370,000 to the IRS and state of California for unpaid taxes in 2011.
  • Nicholas Cage – At one time owed the IRS more than $14 million.
  • Jim Thorpe – The professional golfer spent time in jail, owing the IRS $2 million in unpaid taxes.

You might wonder how these amounts are so large? The penalties and interest that the IRS will add to taxes owed can be quite onerous, and they can pile up quickly.

How will NIL income be treated?

This is a critical question to ponder. Once again, we can look to professional athletes and celebrities to see how the IRS views this type of income. Basically, it can be treated in one of two ways: as royalty income or as professional services income. And there is a significant difference in how much in taxes you will pay depending on this treatment.

Professional services income is considered “earned income” that is subject to FICA (social security and medicare) taxes. Therefore, this is considered business income, and in addition to income tax paid on these earnings, the taxpayer will also be obligated to pay FICA taxes of 15.3% (a portion of which maxes out at higher income levels). On the other hand, royalty income is not subject to FICA taxes, so the more that is classified as royalty income the better.

So how do you determine whether your NIL income is royalty income, professional services income, or some combination of both? We can get some insight from previous tax court cases, and in particular U.S. vs. Goosen. This was a 2011 court case involving Retief Goosen, a professional golfer who had a dispute with the IRS in regards to the classification of his income. Although the focus on this case was primarily whether the income was U.S. based or foreign based, it still provides insight and sets some precedents in how this type of income is classified. And a lot of it depends on the language in the contract.

However, here are some basics. If the compensation depends on you being physically present at an event, it is professional services income. For example, the athlete is present at a car dealership on a Saturday afternoon to promote the business, this is professional services income. In contrast, if the athlete is being compensated just for the use of his or her name or likeness, with no other obligations on the part of the athlete, then this would be royalty income. For example, let’s say EA Sports comes out again with college sports games with player likenesses, and the athletes get a check from EA sports for this. That is clearly royalty income. Sounds simple, right.

However, it can get more complicated. What if the athlete is being compensated for his or her likeness, but the athlete is required to pay in x number of games during that season to earn the fee? Or the fee is adjusted based on how often they play? Then you are likely to have some mix of royalty income and professional services income. In this arrangement, you should consider finding a tax expert to advise you, so that you both avoid issues with the IRS, but you also minimize the amount of taxes you pay.

Tax planning issues

There are legal ways to minimize some of these taxes. For example, you are able to deduct certain expenses from your personal services income to determine your taxable income. Also, for athletes who will likely have higher amounts of personal services income (a minimum of $50,000 – $75,000 per year), it may make sense to set up a loan-out corporation, which can help to reduce the FICA taxes owed. A tax advisor can assist you in determining if this makes financial sense and guide you through the process.

State tax issues

It’s not only the IRS who will be looking at this for new revenue, but also states that have personal income taxes. Keep in mind that you may owe tax in every state where you make appearances for a fee (except for those states with no state income tax). Also, your state of residence will tax all of your income, although most will give you credit for taxes paid to another state. What if your parents live in a state without a state income tax, and you go to school is a state that does have an income tax. Which state is your state of residence? This could have a significant impact on the taxes you will pay.

Conclusion

It is exciting to see that college athletes will now be compensated for their efforts, and this will be a financial windfall for many athletes that will allow them to support their families. However, along with that comes a requirement to make sure this income is not wasted through paying penalties and interest for failing to file or pay taxes. The IRS is good at tracking this type of activity, so it is not likely you can avoid paying taxes on this income. Athletes should always set aside a certain percentage of earnings to pay these taxes, and make quarterly estimated payments to ensure no interest charges are incurred. Finding a tax advisor to help sort through these complex tax issues and stay on top of compliance is a must.

If you would like to set up a free initial consultation to discuss your situation, give me a call at (479) 876-9980, ext. 102, or email me at Brent@seaycpas.com.