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May 23, 2024 | read

61. The Ultimate Guide to Tax Planning for Landlords and Buy and Hold Investors

Ben Isley

In this episode, The Real Estate CPA CEO Brandon Hall flies solo to dive into several sections of the recently published Ultimate Guide to Tax Planning for Landlords and Buy and Hold Investors. Check out the sections below for more info on the topics Brandon covered today.

Find the guide on our website: https://www.therealestatecpa.com/the-ultimate-guide-to-tax-planning-for-landlords-and-buy-hold-real-estate-investors

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10. Is Your Expenditure a Repair or Improvement?

After a property is in service, you’ll need to determine whether each repair and maintenance or renovation expenditure you incur should be classified as a regular expense or a capital improvement. Capital improvements are depreciated over the life of the capitalized asset, unless you can apply 100% bonus depreciation. Most landlords and buy and hold real estate investors will prefer to classify these costs as regular repair and maintenance expenses in order to maximize current year deductions and minimize depreciation recapture.

Repairs and maintenance are generally one time expenses that are incurred to keep your property habitable. To give you an idea of costs that qualify as repairs, we’ve listed common examples below:

  • Painting 
  • Fixing an AC unit or leaky plumbing
  • Patching holes in the wall
  • Replacing a small part of the flooring or roof
  • Replacing cabinet doors
  • Repairing appliances
  • Inspection costs
  • Replacing broken parts

A capital improvement is expenditure that increases a property’s value, useful life, or adapts it (or a component of the property) to new uses. These items fall under categories sometimes called betterments, restorations, and adaptations. Examples that constitute capital improvements include:

  • Full blown additions (e.g. additional room, deck, pool, etc.)
  • Renovating an entire room (e.g. kitchen)
  • Installing central air conditioning, new plumbing system, etc.
  • Replacing 30% or more of a building component (i.e. roof, windows, floors, electrical system, HVAC, etc.)

Determining whether your expenditure is a repair or improvement is not as straightforward as it may seem. First, you need to identify the Unit of Property that the expenditure affects. There are nine Units of Property: the building structure, HVAC systems, plumbing systems, electrical system, escalators, elevators, fire-protection and alarm systems, security systems, and gas distribution systems. 

You must then apply the De Minimis Safe Harbor, the Routine Maintenance Safe Harbor, and the Safe Harbor for Small Taxpayers. If your expenditure fails all of the tests associated with those three safe harbors, you will move on to the Betterment, Adaption, Restoration tests. After working your way through these safe harbors and tests, you’ll know whether your expenditure qualifies as a repair or is considered a capital improvements that must be depreciated. 

Below is a high level overview of the Betterment, Adaption, Restoration tests. 

An expenditure will fall under a Betterment if it ameliorates a “material condition or defect” in the UOP that existed before it was acquired, it is for a “material addition” to the UOP, it materially increases the size or capacity of the UOP, or materially increases the productivity, efficiency, or strength of the UOP.  “Material” in the case of Betterments generally means 30%, though there is no bright-line test. Thus, if you buy a 10 unit apartment complex and replace 2 HVAC units, you will have replaced 20% of the HVAC system. While the HVAC replacements will be too expensive for any of the three safe harbors previously discussed, they do not materially improve the UOP and therefore can be deducted. 

An expenditure will be a Restoration if it replaces a major component or substantial structural part of a UOP or rebuilds the UOP to like-new condition. As with the Materiality threshold for Betterments, we aim for 30% when attempting to define “major” or “substantial” however the Regulations make no mention of a numerical threshold. 

An expenditure is an Adaptation if a UOP is modified to serve a new and different use no consistent with the original ordinary use.


11. Three Safe Harbors Every Landlord Should Know

As discussed in the above section, there are three safe harbors related to repairs and maintenance that every landlord and buy and hold real estate investor should know. Those three safe harbors are:

  1. The De Minimis Safe Harbor
  2. The Routine Maintenance Safe Harbor
  3. The Safe Harbor for Small Taxpayers

The De Minimis Safe Harbor is found under Reg. Sec. 1.263(a)-1(f). Landlords may use the De Minimis Safe Harbor to deduct up to $2,500 of the costs of tangible property used to produce or acquire rental real estate. This deduction limit is applied at the “invoice” level. Such tangible property includes materials and supplies as well as installation (labor) costs. The safe harbor does not apply to materials and supplies for use in manufacturing inventory; thus if you were to flip property, you cannot use the DMSH. 

There is an anti-abuse rule which does not allow you to manipulate a transaction to ensure all costs related to the tangible property fall below the $2,500 threshold. For example, if an HVAC unit costs $4,000 for parts and labor, you cannot divide up the costs as the property must be looked at in the aggregate. 

The Routine Maintenance Safe Harbor is found under Reg. Sec. 1.263(a)-3(i). There is no limit on the amount you can deduct under this safe harbor. 

Routine Maintenance is work the landlord performs on a property to keep the building and each of the building’s systems in operating condition. This generally includes inspecting and cleaning components of the building or structure and then replacing the damaged or worn parts.

In order for costs to count under the Routine Maintenance Safe Harbor, you must reasonably expect to perform such maintenance more than once every ten years (i.e. replacing carpet every 4-5 years). This rule eliminates the replacement of larger components, such as roofs, windows, and tile/wood flooring. Landlords may not deduct costs under the Routine Maintenance Safe Harbor that qualify as Betterments or Restorations. Thus, major repairs and remodeling will not qualify, however defects discovered during routine inspections will qualify.

Found in Reg. Sec. 1.263(a)-3h, the Safe Harbor for Small Landlords allows real estate investors to deduct all of their repairs and maintenance on a property as long as the property’s unadjusted basis is less than $1MM and the total aggregate cost of the repairs, maintenance, and improvements for that property during the year were less than $10,000 or 2% of the unadjusted basis on the building, whichever is less.

This safe harbor is generally claimed in years in which properties did not incur large repair or maintenance expenses but did inclur a large capital expenditure. 

For example, assume you own a property with an unadjusted basis of $300,000. This property required $0 of repair and maintenance during the year but did require a replacement HVAC costing $4,000. Because 2% of $300,000 is $6,000 and that is less than $10,000, $6,000 is the threshold that, if we stay under, we can deduct the cost of the HVAC in full. Because the HVAC cost only $4,000, and because our other maintenance and repairs were $0, we can fully deduct the cost of the new HVAC.


12. Can You Deduct the Losses Your Rentals Create?

As a rental property owner it’s not uncommon for your properties to produce a net loss for tax purposes thanks to depreciation and other operating expenses. The treatment of these losses is often misunderstood by landlords for various reasons, so we’ll spend some time here to clear up common misconceptions.

Losses from rental property are considered passive losses and can generally only offset passive income (i.e. income from other rental properties or another business in which you do not materially participate, not including investments). If these passive losses exceed your passive income, they are suspended and carried forward indefinitely until future years, when you either have passive income or sell a property at a gain.

However, if you actively participate in your rental activity, and make management decisions, then under the passive activity limits you can deduct up to $25,000 in passive losses against your ordinary income (e.g. W-2 wages) as long as your modified adjusted gross income (MAGI) is $100,000 or less. This deduction begins to be phased out by $1 for every $2 of MAGI above $100,000 until your MAGI hits $150,000, at which point the deduction is completely phased out. 

If you’re MAGI is above $150,000, the passive losses generated from your rental real estate will become suspended and carried forward. However, not all is lost as there are strategies to tap into suspended passive losses. Of course, to avoid this altogether you or your spouse can qualify as a real estate professional. 

A quick note: many of our high net worth clients assume that rental real estate is not helping them if they cannot claim the losses. This is far from the truth. What these landlords fail to realize is that, while the have suspended passive losses that they are carrying forward, they also received cash flow from the rental real estate that they didn’t pay tax on. This results in a reduction of the landlord’s effective tax rate. 


13. The Power of Qualifying as a Real Estate Professional

One of the greatest advantages to owning real estate rentals for high-income earners is the “Real Estate Professional” status. Qualifying as a real estate professional, and also demonstrating material participation in your rental activities, will allow landlords to fully deduct the losses created from their rentals against their (or their spouse’s) ordinary income. When landlords and buy and hold real estate investors combine the real estate professional status with cost segregation studies and 100% bonus depreciation, they can effectively eliminate their, or their spouses, ordinary income resulting in a very low or $0 tax bill. 

Two quick points about the real estate professional status that we want you to ingrain into your brain:

  • You absolutely, 100%, do not need a real estate salesperson license to qualify as a real estate professional. The real estate professional designation is based on hours spent in IRS mandated activities and has nothing to do with being a real estate agent. 
  • You absolutely do need to understand that qualifying as a real estate professional is only the first step to claiming an unlimited amount of passive losses. The second step is demonstrating material participation in your rental real estate activity. Without material participation, you won’t be able to claim your losses!

To qualify as a real estate professional, you or your spouse must work 750 hours in a real estate trade or business and more than half of your working hours need to be dedicated to your real estate trade or business. A real estate trade or business can be real estate sales, development, leasing, and construction, or managing a rental portfolio.

There are seven tests to demonstrate material participation, however the most common tests we see used are spending more than 500 hours on your rental real estate activity or 100 hours and more than anyone else. 

A key issue is that you must materially participate in each rental real estate activity separately unless you group them together as one activity under IRC Sec 1.469-9. When you make an election to group your rental real estate activities into one activity, you must only materially participate in the one activity. Be careful with this election as it can certainly result in unforeseen issues. 

If you or your spouse qualify as a real estate professional, and if you demonstrate material participation, your rental real estate losses will be considered non-passive and can be used to offset other non-passive income. To show how hard-hitting this is, let’s assume your spouse makes $300,000 at her W-2 job and you are investing in real estate full-time. You qualify as a real estate professional and materially participate in your rental real estate activities. You decide to buy a $1MM apartment building and, after running a cost segregation study, you are able to allocate 30% of the purchase price to 5, 7, and 15 year property. This means that you can use 100% bonus depreciation on this property effectively providing you with a $300,000 first-year depreciation deduction. That will most certainly create a large loss that you will be able to use to drastically offset your spouse’s W-2 income.