Real Estate Investors: Is that expenditure a Repair or Improvement?

Determining whether an expenditure is a repair (expense) to write-off in the current year or an improvement (capitalized) to depreciate over many years sometimes causes confusion for the real estate investor and even a CPA. As always, the decision for whether a cost is a repair or an improvement will require reviewing the facts and circumstances. Here are the steps to determine whether your expenditure is a repair or improvement.

Step 1: Identify the Safe Harbor

First, walk through the three safe harbors allowed in the tangible property regulations:

1. De Minimis Safe Harbor – Reg. §1.263(a)-1(f)
2. Routine Maintenance Safe Harbor – Reg. §1.263(a)-3(i)
3. Small Taxpayer Safe Harbor – Reg. §1.263(a)-3(h)

De Minimis Safe Harbor – Landlords may use this safe harbor to deduct up to $2,500 of the costs of materials, supplies, or other tangible property used to improve or acquire rental real estate. This limit is applied at the item or invoice level, but there is an anti-abuse rule that does not allow you to manipulate an invoice or transaction to ensure the limit of $2,500 is not reached. For example, if a furnace were purchased for $3,000, the component parts of the furnace could not be separated to get below the $2,500 threshold. Therefore, the furnace is not eligible for this deduction.

Routine Maintenance Safe Harbor – Unlike the De Minimis Safe Harbor, there is no limit a landlord can deduct for this safe harbor. Maintenance of a building or building system is considered routine if it is expected to be performed more than once over a 10-year period. The landlord does not have to actually perform maintenance more than once every 10-year period, it simply needs to be expected that the maintenance will need to be performed. For example, if new carpet were placed in service this year and you expected to replace it every four years, but it wasn’t actually replaced until years seven and 12, that expenditure would still be a legitimate expense under this safe harbor.

Small Taxpayer Safe Harbor – The landlords with average annual gross receipts of $10 million or less for the preceding 3 tax years and the building with an unadjusted basis of $1 million or less can expense improvements if the total cost is either A) the lesser of 2% of the unadjusted basis in the building or B) $10,000. This safe harbor is not as commonly used as the other two safe harbors but is perfect for landlords with a single large repair during the year. For example, if you were a qualifying small taxpayer with an unadjusted basis in a building of $750,000, and you accumulated repairs and maintenance expenditures for the year totaling $8,000, the full amount may be deducted in the current year, because the total repairs and maintenance is the lesser of $15,000 (2% of $750,000) or $10,000.

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Step 2: Test the Purpose – Betterment, Adaptation, and Restoration

Second, after walking through the safe harbors above, landlords will then determine if the expenditure is a betterment, adaptation, or restoration. To begin, landlords will decide which unit of property the expenditure belongs to. There are 9 units of property identified by the IRS: Building Structure, Plumbing, Electrical, HVAC, Escalator, Elevator, Fire protection and alarm, Gas distribution, and Security.

Once the unit of property has been identified, the landlord will evaluate whether the improvement is considered a:

1. Betterment – Reg. §1.263(a)-3(j)
2. Adaptation – Reg. §1.263(a)-3(l)
3. Restoration – Reg. §1.263(a)-3(k)

Betterment – These improvements are usually performed either: 1) to fix a material defect that existed before the purchase of the unit of property; or 2) a material addition to the property which is any material enlargement, expansion, extension, or addition of a major component; or 3) a material increase in productivity, efficiency, strength, quality, or output of the unit of property. For example, adding insulation to a building to increase energy efficiency and significantly reduce utility costs provides a material increase.

Adaptation – Improvements to a unit of property to a new or different use from the original use. For example, converting an apartment building into a commercial office space.

Restoration – Improvements considered a restoration generally are costs incurred to bring the unit of property back to working order, or to like-new condition, or to replace a major component or substantial structural part of a unit of property. This test is most commonly met by developers who will flip a distressed property to like-new condition.

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Step 3: Connect it to the Financial Statements

If your expenditure falls into one of the three safe harbors, then you have an expense on your Profit & Loss for the current year.

If the expenditure falls into either a betterment, adaptation, or restoration, then you need to capitalize the expenditure on your Balance Sheet and depreciate the expenditure over its IRS designated useful life.

Taking as much of a deduction as possible in the current year can often lead to significant tax savings, so getting this right is extremely important in saving money on taxes.