Determining whether expenses qualify as repairs or improvements can mean the difference between a couple hundred dollars of tax savings and a couple thousand. Knowing these rules will help you navigate rehab projects and structure your tax position more efficiently.To determine if an expense can be counted as a repair versus a capital improvement, we will want to check to see if we can use any of the following three safe harbors:
- Safe harbor for small taxpayers
- Routine maintenance safe harbor
- De Minimis safe harbor
If we cannot use the safe harbors, we must then look to the Unit of Property (UOP) affected by the repair and ask whether that repair was a Betterment, Adapation, or Restoration to the unit of property I question.
Expenses will be considered betterments if they:
- ameliorates a “material condition or defect” in the UOP that existed before it was acquired
- is for a “material addition” to the UOP—for example, physically enlarges, expands, or extends it, or adds a new component
- is for a material increase in the capacity of the UOP, such as additional cubic or linear space, or
- is reasonably expected to materially increase the productivity, efficiency, strength, or quality of the UOP or its output (the productivity and output factors don’t usually apply to buildings). (IRS Reg. § 1.263(a)-3(j)(1).)
Only material changes to the UOP are betterments that must be depreciated. While there are no bright lines as to what “material” is, several examples in the IRS Regs, as well as court cases, hint that anything less than a 25% in a UOP’s capacity, efficiency, or quality would not be viewed as material.
Extensive building remodels would be considered betterments but a building refresh every so often consisting of cosmetic updates, such as repairing the flooring, moving or removing walls, and structural fixes are not considered betterments (IRS Reg. § 1.263(a)-3(j)(3), Ex. 6).
A repair will not be considered a betterment if you replace part of a UOP with an improved, but comparable, due to the old part not being available. For example, if you replaced a steel door with a wooden door because steel doors were not available, you could classify the expense as a repair rather than a capital improvement.
You must capitalize and depreciate expenses related to adapting a UOP to a new or different use.
A new or different use occurs when the UOP that was originally placed in service is converted to provide a different function, such as converting apartments to office spaces (IRS Reg. § 1.263(a)-3(l)).
Expenses will be considered restorations if they:
- replace a major component or a substantial structural part of a UOP
- rebuild the UOP to like-new condition after it has fallen into disrepair
- replace a component of a UOP and deduct a loss for that component (other than a casualty loss)
- replace a component of a UOP and realize gain or loss by selling or exchanging the component
- restore damage to a UOP caused by a casualty event and make a basis adjustment to the UOP (see Chapter 13), or
- rebuild a UOP to like-new condition after the end of its IRS class life. (IRS Reg. § 1.263(a)-3(k)).
Replacing a major component or a substantial structural part of a UOP will be considered a restoration and the cost must be capitalized and depreciated. A “major component” is a part or combination of parts that perform a discrete and critical function in a UOP. A “substantial structural part” of a UOP is a combination of parts that comprise a large portion of the UOP’s physical structure.
Examples of a major component would be the wiring of the electrical system or the blower in a furnace.
Examples of a substantial structural part would be the windows, roof, and doors of a building.
If a significant portion of a major component (defined above) of the building or any UOP is replaced, the cost of the replacement will count as a restoration (Reg. § 1.263(a)-3(k)(6)(ii)(A)) and will have to be capitalized and depreciated. Examples in the IRS Regulations seem to indicate that replacing less than 30% of a major component of a UOP will avoid the replacement being classified as “significant.”
Examples of restorations that would cause you to capitalize and depreciate the expense:
- Replacing two-thirds of a building’s windows (IRS Reg. § 1.263(a)-3(k)(7), Ex. 26).
- Replacing the entire leaky roof on a property (IRS Reg. § 1.263(a)-3(k)(7), Ex. 14).
- Replacing the only chiller unit of the HVAC system (IRS Reg. § 1.263(a)-3(k)(7), Ex. 17).
- Replacing all electrical in a property (IRS Reg. § 1.263(a)-3(k)(7), Ex. 20).
- Replacing all plumbing in a property (IRS Reg. § 1.263(a)-3(k)(7), Ex. 22).
Examples of restorations that would not be considered material to the UOP or major component of the UOP and would therefore qualify as a currently deductible repair:
- Replacing one-third of the building‘s windows (IRS Reg. § 1.263(a)-3(k)(7), Ex. 25).
- Replacing a portion of the leaky roof (IRS Reg. § 1.263(a)-3(k)(7), Ex. 15).
- Replacing one of three furnaces in an HVAC system (IRS Reg. § 1.263(a)-3(k)(7), Ex. 16).
- Replacing only 30% of a building’s electrical system (IRS Reg. § 1.263(a)-3(k)(7), Ex. 21).
- Replacing a portion of a building’s plumbing fixtures (IRS Reg. § 1.263(a)-3(k)(7), Ex. 23).
Other notes about repairs and improvements
Often, repair work is combined with improvement work and it is hard to differentiate the two. Great documentation is required in order to support a repair deduction because the IRS requires that a taxpayer depreciate all the direct costs of an improvement, and all the indirect costs that directly benefit from, or are incurred due to, an improvement.
Repair and maintenance expenses incurred at the same time of an improvement to a UOP will not be depreciated if the repair/maintenance does not directly benefit from the improvement and if the repair/maintenance cost was not incurred due to the improvement to the UOP (IRS Reg. § 1.263(a)-3(g)(1)(i)).
In example 24 of IRS Reg. § 1.263(a)-3(k)(7), a hotel owner replaces bathroom fixtures which is considered an improvement to the UOP. As a result of the improvement, he also needs new flowing and paint. The cost of these items would be considered an improvement because they happened due to the improvement to the UOP.