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Real estate investors and landlords stand to save plenty of tax dollars by knowing how and when to use the following three safe harbors. Once you understand the "how" and "when" you may find yourself better structuring repair and maintenance schedules on your rental properties. Our clients use these safe harbors to save thousands of dollars in taxes each year.
De Minimis Safe Harbor
The De Minimis Safe Harbor (DMSH) (IRS Reg. § 1.263(a)- 1(f)) is one of three safe harbors enacted due to the IRS repair regulation issued in 2013.
Landlords may use the DMSH to deduct any cost as substantiated by the invoice as long as that cost does not exceed $2,500 ($5,000 if you have applicable financial statements). This dollar limit is applied to each item on the invoice, not the invoice in the aggregate. As a result, it is critically important to itemize all invoices.
The limit was originally $500 when released in 2013 but the IRS later retroactively applies an increased $2,500 limit.
There is an anti-abuse rule which prevents landlords from breaking down the cost of a component into each of its individual parts on an invoice. For example, you cannot deduct the cost of a new HVAC if the total cost was $4,000 by breaking up that cost into the HVAC’s individual parts on the invoice.
Routine Maintenance Safe Harbor
The routine maintenance safe harbor (IRS Reg. § 1.263(a)-3(i)) is another safe harbor enacted due to the IRS repair regulation issued in 2013.
Expenses that qualify as routine maintenance under this safe harbor are currently deductible regardless of cost. There are no annual dollar limits and any landlord can use this safe harbor regardless of income levels.
Routine maintenance is recurring work a landlord does to keep an entire building, or each of the building’s nine systems (units of property), in ordinarily efficient operating condition.
Specifically, routine maintenance is carried out through two activities:
- Inspection, cleaning, and testing of the building’s units of property
- Replacement of damaged or worn parts with comparable and commercially available replacement parts
The first activity has generally always been deductible but the second activity of deducting replacement parts is where this safe harbor helps landlords. Previously, landlords may have been required to capitalize and depreciate replacement parts. However, landlords may now currently deduct these costs without regard to total expense.
There are limits that must be met; the 10-year rule and no betterments rule.
The 10-year rule states that the replacement part will qualify as routine maintenance only if you reasonably expect to perform such maintenance again within the next 10 years. Basically, you must expect to make the same replacement twice within a 10 year period. This rule typically eliminates the ability to deduct larger components of the building such as roofing, windows, HVAC, and land improvements.
The no betterments or restorations rule prevents landlords from deducting capital improvements and ensures that costs deducted under this safe harbor are only those that keep the property in ordinarily efficient operating condition. The maintenance must be attributed to the taxpayer’s use, not that of a prior owner. This limitation excludes rehabilitation costs from being classified as routine maintenance.
A word of warning: costs deducted under the routine maintenance safe harbor also count against the annual allowance under the safe harbor for small taxpayers.
To claim the routine maintenance safe harbor, you must adopt it as a method of accounting m. Unlike the safe harbor for small taxpayers, you do not make an annual election with your tax return.
Safe Harbor for Small Taxpayers
The Safe Harbor for Small Taxpayers (SHST) is the final safe harbors enacted due to the IRS repair regulation issued in 2013.
The SHST allows landlords to currently deduct on Schedule E all annual expenses for repairs, maintenance, improvements, and other costs for a rental building (IRS Reg. § 1.263(a)-3h).
There are restrictions to qualify (listed below) but landlords need to ensure they keep careful track of all their annual expenses for repairs, maintenance, and improvements to justify the use of the safe harbor.
Rental Business Size Limitations
Landlords cannot use this SHST in any year that the following limitations are exceeded:
- $1 Million limit on unadjusted basis – note that unadjusted excludes land, land improvements, and personal property identified through a cost segregation study
- Annual expenses for repairs, maintenance, and improvements, cannot exceed the lesser of $10,000 or 2% of the building’s unadjusted basis
- Annual gross income for the landlord must be less than $10MM for the three preceding tax years.
If you qualify for the SHST, you won’t have to worry about determining if you have repairs or improvements nor will you have to worry about the De Minimis Safe Harbor or Routine Maintenance Sade Habor.