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.

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.

Real Estate, Taxes and COVID-19

It has certainly been an unusual and challenging year. The COVID pandemic has impacted our lives in many ways, and as we gear up for tax season, you need to be aware of how it will impact your 2020 taxes that will be filed early next year. For real estate owners and developers, below are some changes to keep in mind as you prepare to file your 2020 taxes and plan for the coming year.

Net operating losses

Congress passed the Tax Cuts and Jobs Act (TCJA) in 2017, and one of the key changes in that legislation was the dis-allowance of carrying back net operating losses to prior years as well as a limitation in the amount of loss carryforwards that can be taken in future years, where the losses can be used to offset no more than 80% of taxable income. However, the Corona Virus Aid, Relief, and Economic Security (CARES) Act postponed the 80% carryforward limitation, and it will now only apply for years beginning on or after January 1, 2021. In addition, taxpayers can also carry back any NOLs that arise in tax years beginning after December 31, 2017, and before January 1, 2021, over a 5-year period.

Corporate Alternative Minimum Tax (AMT) Credit

The TCJA of 2017 eliminated the 20% corporation AMT that principally impacts C corporations, and provided that only 50% of the AMT credits carried forward could be refundable in tax years after December 31, 2017 and before January 1, 2021. After December 31,2020, 100% of any excess AMT credits could then be refunded. However, the CARES Act permits corporations to claim a refund for 2018 equal to the full amount of their excess AMT credit carryforwards. For corporations that do not elect to take this refund, the CARES Act eliminates the 50% limitation on AMT credits for taxable years beginning in 2019.

Business Interest Expense Deduction

The TCJA limited the amount of business interest expense that a taxpayer can deduct. Under IRC Section 163(j), taxpayers may deduct business interest expense only up to 30% of their adjusted taxable income. However, the CARES Act increases the limitation to 50% for taxable years beginning in 2019 and 2020, and it also allows taxpayers to elect to use their 2019 adjusted taxable income for their 2020 taxable year, benefitting taxpayers that have had their income impacted by COVID-19.

For partnerships, the IRC Section 163(j) limitation still applies at the partnership level. the 30% limitation will continue to apply to partnership interest expense in 2019. However, 50% of any excess business interest allocated to a partner and carried over from 2019 will be treated as business interest paid by the partner in 2020 and will not be limited to the partner’s business interest income for 2020. The remaining 50% will continue to be subject to such limitations.

Bonus Depreciation for Qualified Improvement Property

Probably the most important change impacting the taxation of real estate involves bonus depreciation involving qualified improvement property. The TCJA permitted taxpayers to deduct the full cost of certain depreciable property placed in service by the taxpayer in a taxable year before January 1,2027. This is commonly referred to as bonus depreciation. Property eligible for bonus depreciation included property with a depreciable life of 20 years or less. While these rules permit immediate expensing for various types of personal property (i.e. equipment, furniture & fixtures, etc.), it was also intended to apply to structural improvements made to commercial properties, including (but not limited to) hotels, restaurants, and retail establishments. However, the general 39-year recovery period for these improvements prevented them from being eligible for immediate expensing.

The CARES Act corrects this “error” by assigning a 15-year depreciable life to “qualified improvement property,” thereby permitting such improvements to be eligible for bonus depreciation. The provision is effective retroactively to property placed in service in 2018 and beyond. This provision may allow taxpayers to file amended returns and claim refunds for 2018 and 2019 tax years if they placed qualified improvement property into service during those years, and it may also encourage taxpayers to make needed improvements in the coming years as the economy recovers from the pandemic.

The CARES Act also revises the definition of “qualified improvement property” to limit that concept to “improvements made by the taxpayer,” thereby eliminating the possibility of the taxpayer getting bonus depreciation for “used” property that was purchased by the taxpayer.

If you invest in real estate, please keep these CARES Act changes in mind as you review your tax planning for the coming years. If you need assistance in better understanding how these changes apply to your investments or real estate business, feel free to contact me at Brent@seaycpas.com or (479) 329-5862.

IRS final regulations regarding Section 1031 like-kind exchanges

On November 23, 2020, the IRS posted final regulations (TD 9935) on its website in regards to changes in the the rules for like-kind exchanges of real estate under IRS Code Section 1031.

Background

Under the Tax Cuts and Jobs Act (TCJA), several amendments were made to Section 1031 rules for the like-kind exchange of real property, as follows:

  • Limited the exchange rules to include only exchanges of real property
  • The deferral rules are no longer allowed for an exchange of property that is held primarily for sale
  • Stated that real property located in the United States is not considered to be like-kind to real property located outside the United States

New guidance

The new release that came out last month provides additional clarification to these new rules. Below are the key clarifications included in the final regulations:

  • Elimination of the purpose or use test in the regulations
  • Adding a definition of real property
  • List of intangible property that is considered real property
  • Adapt an existing incidental property exception to apply to a taxpayer’s receipt of personal property that is incidental to real property the taxpayer receives in the exchange.

Elimination of purpose or use test

Real property includes land and improvements to land, both permanent structures and structural components of inherently permanent structures. The earlier prpoosed regulations also took into consideration the function of the property in determining whether it is real property per section 1031. Tangible property, such as machinery or equipment, nor intangible property were classified as real property if the property contributes to the production of income unrelated to the use or occupancy of the space. The following example was included in the earlier guidance:

For example, a gas line installed for the sole purpose of providing fuel to fryers and ovens in a restaurant is not a constituent part of an inherently permanent structure and therefore not real property under the proposed regulations.

IRS Publication TD 9935

Based on feedback from commenters on the proposed regulations challenging the need for the purpose or use test and the cost of cost segregation studies that would be required, the Treasury Department and the IRS agreed and have eliminated the purpose or use test.

Definition of real property

Per the new guidance, “..property is classified as real property for section 1031 purposes if, on the date it is transferred in an exchange, the property is real property under the law of the State or local jurisdiction in which that property is located.” The final regulations also eliminate, with regard to both tangible and intangible properties, any consideration whether the property contributes to the production of income (i.e. purpose or use test). Finally, although the IRS is following state or local definitions of real property, the regulations do exclude from the definition intangible assets listed in section 1031(a)(2) prior to its amendment of TCJA, regardless of state or local law.

Intangible property as real property

The final regulations include the following intangible assets as real property defined in section 1031:

  • Fee ownership interests
  • Co-ownership interests
  • Leasehold interests
  • Option to acquire real property
  • Easements
  • Stock held by a person as a tenant-stockholder in a cooperative housing corporation
  • Rights to develop land
  • Licenses, permits, or other similar rights that are solely for the use, enjoyment, or occupation of land or an inherently permanent structure

Incidental property exception

The proposed regulations issued earlier this year provided for the receipt of personal property that is incidental to the taxpayer’s replacement real property. Personal property is considered to be incidental to real property acquired in an exchange if both of the following are true:

  • In standard commercial transactions, the personal property is typically transferred together with the real property.
  • The aggregate fair market value of the incidental personal property transferred with real property does not exceed 15% of the aggregate fair market value of the replacement real property.

The final regulations clarified that the 15% limitation is to be applied in the aggregate for the transaction and not on a property-by-property basis.

Summary

The final regulations on like-kind exchanges are a reflection of the Treasury Department and the IRS accepting constructive feedback on the changes in the TCJA, with the final regulations reflecting feedback received after the preliminary regulations were issued. The full 75-page regulations can be found at the following link: https://www.irs.gov/pub/irs-drop/td_9935.pdf

Tax regulations related to real estate are complex. If you need assistance working through these types of issues, give The Seay Firm CPAs a call. We specialize in real estate, and we can help you figure out the best tax strategy for your situation.