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If you own investment properties, they’ll inevitably need maintenance and repairs. This is part and parcel of owning property. The good news is many of these expenses are tax-deductible.
Repairs and maintenance expenses are markedly different from capital improvements. While you can deduct repair and maintenance expenses in the year you incur them, capital improvements are depreciated over a longer period: anywhere from 5 years for tangible property to as many as 39 years in the case of the actual building or structure.
It’s almost always preferable to expense repairs and maintenance in the year you incur them. Doing so allows you to deduct them from your taxable income. There’s an additional, long-term benefit to this approach too: expensing repairs and maintenance keeps depreciation low, minimizing the amount of depreciation recapture you’d be subject to when you sell the property.
To classify these repair and maintenance costs as expenses, you’ll need to ensure these expenses fall under a safe harbor or are not considered as a betterment, restoration, or adaptation. This is a complex area of the tax code and successfully navigating repair regulations often requires the support of experienced tax professionals.
However, there are certain foundational principles that investors should understand. Having a basic knowledge of these concepts will maximize your ability to expense certain costs incurred through your ownership of an investment property. In this guide, we’ll explore these principles and share how they can be applied to your property portfolio.
An Overview of Safe Harbors
The issuance of the final tangible property regulations in 2013 created a framework that helps investors and tax professionals determine which of their expenses are deductible and which must be capitalized.
A major element of these regulations was the establishment of three safe harbors. These are intended to simplify the determination of whether an expense must be deducted or capitalized. For repair regulations, three main safe harbors apply:
- De Minimis Safe Harbor
- Safe Harbor for Small Taxpayers
- Routine Maintenance Safe Harbor
If a repair cost fits the criteria of one of these three safe harbors, it’s deductible. Let’s take a closer look at each of the safe harbors.
De Minimis Safe Harbor
Of these three safe harbors, the de minimis safe harbor is the most popular. It allows investors to deduct any individual line item on an invoice costing less than $2,500, regardless of whether it would ordinarily be considered a capital improvement. If you have Applicable Financial Statements (AFS), the threshold increases to $5,000. This typically only applies to a small group of taxpayers.
Major household appliances are examples of items that are typically deductible under the de minimis safe harbor. Ordinarily, these would be depreciated over a five-year schedule, but using the de minimis safe harbor, the full cost could be expensed in the year the appliance is purchased.
There are several intricacies to be aware of when it comes to navigating the de minimis safe harbor.
Your invoices must be itemized. If labor is included on the invoice, it must be reasonably applied to each line item. You could pro-rata labor charges equally between line items or you can apply these costs toward specific line items. If the cost of labor and materials exceeds $2,500, you must capitalize and depreciate the cost. Because of this, it’s best practice to keep labor and materials on separate invoices where possible.
An additional concept to keep in mind is that the de minimis safe harbor can only be applied to one unit of property. If you’re using it to deduct a new fridge, that’s straightforward, but if you’re installing a new roof, you cannot itemize each bundle of shingles. The entire roof is considered one unit of property.
You should systematically account for these expenses within your accounting software. You might have many of these expenses throughout the year and if you automatically expense them in your accounting system, it makes things much easier when it's time to file taxes.
Safe Harbor for Small Taxpayers
It’s possible to immediately expense all repairs, maintenance, and improvement expenditures provided that the costs of these do not exceed the lesser of $10,000 or 2% of the unadjusted basis of the property.
In recent years, this safe harbor has become less feasible due to the rising costs of construction. In practice, only minor repairs and maintenance costs can be deducted using this safe harbor, and it’s often better to use the de minimis safe harbor in these instances.
Routine Maintenance Safe Harbor
The routine maintenance safe harbor allows taxpayers to deduct routine maintenance expenditures that are necessary to keep the property in ordinary operating condition. Repairs are considered routine if you reasonably expect to perform them more than once every ten years, starting from when you put the property in service.
If you own a rental property and replace the carpets every few years in between tenants, you could likely deduct this cost under the routine maintenance safe harbor. However, the routine maintenance safe harbor is unlikely to apply to maintenance on major systems such as HVAC systems or roofing structures. These expenditures are more likely to be considered a betterment, restoration, or adaptation, and as such, treated as a capital improvement.
If your expenses don’t meet the criteria of any of the safe harbors, your next step should be to determine whether they would be defined as a capital improvement. There are three main types of capital improvements: betterments, restorations, and adaptations. Provided the expense doesn’t fall under one of these categories, you should still be able to deduct it.
Let’s take a closer look at each of the three main categories of capital improvements.
Betterments are defined as the amount paid to ameliorate a material condition or defect that existed before the taxpayer acquired the unit of property, or arose during the production of the property, or is a material addition to the unit of property, or is expected to result in a reasonable increase in the property’s capacity for efficiency, strength, quality, or output.
That’s not the easiest definition to untangle, so let’s look at a couple of examples that illustrate what a betterment actually is.
Let’s say you own a commercial property used for a retail business. One day, the roof of the building begins to leak due to wear and tear in the roof membrane. So you hire a contractor to replace the damaged roof membrane with a comparable new roof membrane.
To determine whether this qualifies as a betterment, compare the building’s structure immediately after the repair to the condition when the structure was first put in service. Repairing the roof membrane does not materially add to the property’s capacity for efficiency, strength, quality, or output. The roof is in the same operating condition as it was before the issues. Therefore, it’s not considered a betterment: you’ve simply restored the roof to its original condition.
On the other hand, let’s say that instead of replacing the damaged roof membrane with a comparable membrane, you decide to use a top-of-the-line roof membrane that’s ten times more waterproof than the old one. That would be considered a betterment: you improved the quality of the structure. As a result, you’d have to capitalize and depreciate the cost of your roof repairs.
A restoration occurs when you return the unit of property to like-new condition or otherwise extend its useful life.
Think back to our example of the commercial property with a leaky roof. Imagine that instead of just replacing the roof membrane, your contractor found significant water damage and recommended you replace the entire roof. The work is carried out. Because the roof performs a discrete, central function of the property, and is a major component of the property, you must treat the replacement of the roof as a restoration. Accordingly, this expense would be capitalized and depreciated.
These subtle nuances underscore the complexities of navigating this section of the tax code. The IRS shares more practical examples online. In reality, these questions must be dealt with on a case-by-case basis and it’s always best to partner with experienced real estate tax professionals.
Adaptations occur when you convert a property to be suited for a different use. Like betterments and restorations, adaptations are also considered a capital improvement.
Let’s say you purchased a commercial warehouse property with the intention of turning it into a self-storage facility. In the process of transforming your warehouse into a self-storage facility, you likely incurred a variety of costs. Because you have adapted the purpose of the property, these costs must be capitalized and depreciated.
Partner With a Tax Expert
Repair regulations are highly complex and successfully navigating them requires a high degree of precision. This process is repeated every year and to claim safe harbors you must make an election on your tax return.
Sometimes, it’s possible to amend tax filings from previous years to address any errors in betterments, restorations, and adaptations. To determine if this is possible, consult a qualified tax advisor: every situation is slightly different and a high level of nuance and expertise is required.
If you need specialized real estate tax advice, you’re in the right place. At Hall CPA, our team has deep expertise in crafting effective tax strategies for real estate investors. We offer a range of tax planning and tax preparation services that will accelerate your journey towards your financial goals.
Contact the team today to learn more about working with us.