Repairs vs. Improvements: Complicated IRS Rules

Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you have to depreciate improvements over as many as 27.5 years.

For example, if you classify a $10,000 roof expense as a repair, you get to deduct $10,000 this year. If you classify it as an improvement, you have to depreciate it over 27.5 years and you'll get only a $350 deduction this year.

That's a big difference.

Unfortunately, telling the difference between a repair and an improvement can be difficult. In an attempt to clarify matters, the IRS issued lengthy regulations explaining how to tell the difference between repairs and improvements.

For more details on current vs. capital expenses refer to the article Current vs. Capital Expenses.

What Is an Improvement Under IRS Rules?

Under the IRS regulations, property is improved whenever it undergoes a:

• Betterment
• Adaptation, or
• Restoration.

Think of the acronym B A R = Improvement = Depreciate.

If the need for the expense was caused by a particular event—for example, a storm—you must compare the property's condition just before the event and just after the work was done to make your determination. On the other hand, if you're correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you've never had any work done on the property, use its condition when placed in service as your point of comparison.

Betterments

An expenditure is for a betterment if it:

• ameliorates a "material condition or defect" in the property that existed before it was acquired or when it was produced—it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
• results in a "material addition" to the property—for example, physically enlarges, expands, or extends it, or
• results in a "material increase" in the property's capacity, productivity, strength, or quality.

Restorations

An expenditure is for a restoration if it:

• returns a property that has fallen into disrepair to its "ordinarily efficient operating condition"
• rebuilds the property to a like-new condition after the end of its economic useful life, or
• replaces a major component or substantial structural part of the property
• replaces a component of a property for which the owner has taken a loss, or
• repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.

Adaptations

You must also depreciate amounts you spend to adapt property to a new or different use. A use is "new or different" if it is not consistent with your "intended ordinary use" of the property when you originally placed it into service.

What Does the IRS Consider a Unit of Property (UOP)?

To determine whether you've improved your business or rental property, you must determine what the property consists of. The IRS calls this the "unit of property" (UOP). How the UOP is defined is crucial. The larger the UOP, the more likely will work done on a component be a deductible repair rather than an improvement that must be depreciated.

For example, if the UOP for an apartment building is defined as the entire building structure as a whole, you could plausibly claim that replacing the fire escapes is a repair since it doesn't seem that significant when compared with the whole building. On the other hand, if the UOP consists of the fire protection system alone, replacing fire escapes would likely be an improvement.

The IRS regulations require that buildings be divided up into as many as nine different UOPs: the entire structure and up to eight separate building systems. An improvement to any of these UOPs must be depreciated.

UOP #1: The Entire Building

The entire building and its structural components as a whole are a single UOP. A building's structural components include:

• walls, partitions, floors, and ceilings, and any permanent coverings on them such as paneling or tiling
• windows and doors
• all central air conditioning or heating system components
• plumbing and plumbing fixtures, such as sinks and bathtubs
• electric wiring and lighting fixtures
• chimneys
• stairs, escalators, and elevators
• sprinkler systems
• fire escapes
• other components relating to the operation or maintenance of the building, and
• roofs.

For example, replacement of a building's roof is an improvement to the building UOP.

UOP #2-9: Building Systems

In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems must be depreciated:

• Heating, ventilation, and air conditioning ("HVAC") systems: This includes motors, compressors, boilers, furnace, chillers, pipes, ducts, and radiators.
• Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste.
• Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site utility equipment used to distribute electricity.
• All escalators.
• All elevators.
• Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers and hoses.
• Security systems: These include window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit.
• Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property line and between buildings.

Using Safe Harbors to Deduct Repairs and Improvements

As the above discussion shows, it can be difficult to determine whether an expense is for a repair or improvement. Fortunately, landlords may use three "safe harbor" rules to bypass the repair-improvement conundrum and currently deduct many expenses regardless of whether they should be classified as improvements or repairs under the IRS regulations. These are:

• the safe harbor for small taxpayers
• routine maintenance safe harbor, and
• de minimis safe harbor.

Safe Harbor for Small Taxpayers

The safe harbor for small taxpayers (SHST) allows landlords to currently deduct all annual expenses for repairs, maintenance, improvements, and other costs for a rental building. However, the SHST may only be used for rental buildings that cost $1 million or less. And the annual SHST deduction is limited to the lesser of $10,000 or 2% of the unadjusted basis of the building. This limit is determined on a building by building basis—for example, if you own three rental homes, you apply the limit to each home separately.

Routine Maintenance Safe Harbor

Expenses that qualify for the routine maintenance safe harbor are automatically deductible in a single year, even if they would otherwise qualify as improvements that ordinarily must be depreciated over several years. Routine maintenance consists of recurring work a building owner does to keep an entire building, or each system in a building, in ordinarily efficient operating condition. It includes:

• inspection, cleaning, and testing of the building structure and/or each building system, and
• replacement of damaged or worn parts with comparable and commercially available replacement parts.

Routine maintenance can be performed and deducted under the safe harbor any time during the property's useful life. However, building maintenance qualifies for the routine maintenance safe harbor only if, when you placed the building or building system into service, you reasonably expected to perform such maintenance more than once every ten years. Moreover, the safe harbor may not be used for expenses for betterments or restorations of buildings or other business property in a state of disrepair.

De Minimis Safe Harbor

Landlords may use the de minimis safe harbor to currently deduct any low-cost property items used in their rental business, regardless of whether or not the item would constitute a repair or an improvement under the regular repair regulations. The safe harbor can be used for personal property and for building components that come within the deduction ceiling. For example, it could be used for the cost to replace a building component like a garage door or bathroom sink. For most landlords, the maximum amount that can be deducted under this safe harbor is $2,500 per item, as shown on the invoice.

All expenses you deduct using the de minimis safe harbor must be counted toward the annual limit for using the safe harbor for small taxpayers (the lesser of 2% of the rental's cost or $10,000).

For the latest IRS rules on repairs and improvements, see the IRS online guide Tangible Property Regulations—Frequently Asked Questions.