Here’s the basic rule from the IRS: An expense is for an improvement if it:
In contrast, expenses you incur that don't result in a betterment, restoration, or adaptation are currently deductible repairs.
Here are some tips to help you ensure that an expense will constitute a repair, not an improvement.
There is no law that says that if something in your rental property is broken it has to be replaced. A replacement is almost always an improvement—not a repair—for tax deduction purposes. You’ll obtain the best tax results if you patch, mend, or fix things that are broken, instead of replacing them. For example:
You’ll be able to deduct the entire cost of repairs in a single year, rather than depreciating them over as many as 27.5 years. Moreover, repairs are usually much cheaper than replacements.
Of course, sometimes an item is so old or worn out, it makes more economic sense to replace it. Also, tenants like shiny new things and sometimes it pays to keep your tenants happy. You should factor these things into the repair or replace equation, plus the fact that you may be able to charge more rent for a unit with new appliances, carpets, or other amenities than one with old mended appliances or other things.
(Learn more about the many tax deductions for landlords.)
When you fix something that is broken you should use the same quality materials and parts it contained originally. Your goal is to restore the item to the condition it was in before it stopped working, not to make it better. Upgrades are usually improvements, not repairs. In one case, a landlord who replaced wooden roof shingles with better composition shingles was found to have made an improvement.
Good documentation is the key to winning any argument with the IRS. Here are some tips for properly documenting your repairs.
Repairs to rental property usually happen after a tenant complains. Document the complaint by writing a note—this can be on your calendar, appointment book, or on an invoice a repairperson gives you. This will help show that something was broken and you had it fixed—which is what a repair is. (For a sample written request for repair form, see Every Landlord’s Legal Guide (Nolo).)
Get an invoice for every repair. Make sure it describes the work in a way that is consistent with a repair, not an improvement. Good words to use include repair, fix, patch, mend, redo, recondition, and restore. An invoice should not include any words that indicate an improvement—for example: improvement, replacement, remodel, renovation, addition, construction, rehab, upgrade, or new. Of course, your invoice will not, by itself, establish whether something is a repair or an improvement—the facts must be consistent with what the invoice says.
Make sure your repairs are classified as such in all your books and accounting records. This problem can easily crop up if you have a bookkeeper or accountant do your books—they may list a repair as a capital improvement. If an IRS auditor sees this, it will be curtains for your repair deduction.
If you’re doing an extensive repair, take before and after photographs to show the extent of the work and that the property has not been made substantially more valuable. Using a digital camera is a good idea because the photos will be automatically dated.
Maintenance means taking steps to prevent your property from breaking down or deteriorating. Preventive maintenance costs are always currently deductible operating expenses. A great way to avoid the repair versus improvement hassle—and to keep your tenants happy—is to keep your rental property well maintained. This will prevent it from breaking or wearing out quickly, thereby avoiding the need for replacements. Examples of preventive maintenance include periodically changing the filters on your heating and air conditioning system, and installing zinc control strips on a wood shake or shingle roof to keep fungus and algae away.
]]>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.
Under the IRS regulations, property is improved whenever it undergoes a:
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.
An expenditure is for a betterment if it:
An expenditure is for a restoration if it:
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.
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:
For example, replacement of a building’s roof is an improvement to the building UOP.
In addition, the following eight building systems are separate UOPs. An improvement to any one of these systems must be depreciated:
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 (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.
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:
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.
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.
]]>For example, if you buy a relatively inexpensive item, you can deduct the expense in one year using the de minimis safe harbor rather than capitalizing it. (When you “capitalize” an asset, you spread writing off the item over several years.) Basically, the de minimis safe harbor allows businesses to deduct in one year the cost of certain long-term property items.
IRS regulations set a maximum dollar amount—$2,500, in most cases—that may be expensed as “de minimis,” which is Latin for “minor” or “inconsequential.” (IRS Reg. §1.263(a)-1(f)). While $2,500 might not seem like a lot of money, this deduction can really add up because there’s no limit on how many items costing up to $2,500 each you can deduct every year.
The de minimis safe harbor is most often used to deduct the cost of tangible personal property items (units of property) you use in your business.
Example. Alex buys two computers for her business at $2,000 each for a total cost of $4,000, as shown on the invoice. By using the de minimis safe harbor, she can deduct the entire $4,000 expense in a single year, provided the requirements to use the safe harbor are satisfied.
This category doesn’t include components acquired as part of a unit of property, such as the original engine in an automobile. Any item with an economic useful life of 12 months or less must be deducted under the de minimis safe harbor if the cost is within the de minimis limit.
You can use the de minimis safe harbor to deduct the cost of property you don’t use 100% of the time for business. Your deduction is limited to the dollar amount of your business use percentage.
Example. Shelby buys a $2,000 camera and uses it 50% of the time for her photography business and 50% of the time for personal purposes. She can deduct $1,000 of the cost using the de minimis safe harbor. But she couldn’t deduct the camera using the safe harbor election if it cost more than $2,500.
This safe harbor can’t be used to deduct the cost of land, inventory (items held for sale to customers), certain spare parts for machinery or other equipment, or amounts that you pay for property that you produce or acquire for resale.
The maximum amount you can deduct under the de minimis safe harbor depends on whether your business has an “applicable financial statement” for the year, such as:
If you don’t have such a financial statement, you may use the de minimis safe harbor only for property that doesn’t cost more than $2,500 per invoice, or $2,500 per item as substantiated by the invoice. (This amount was $500 in the original version of the regulation, but the IRS increased it to $2,500 effective in 2016.) If the cost exceeds $2,500 per invoice (or item), no part of the cost may be deducted by using the de minimis safe harbor.
Example: Alex, from the above example, purchased two computers for her business at $2,000 each for a total cost of $4,000 as indicated by the invoice. Alex has accounting procedures in place at the beginning of the year to expense amounts paid for property costing less than $2,500, and she treats the amounts paid for the computers as an expense on her books and records. The amounts paid for the computers meet the requirements for the de minimis safe harbor. Alex may currently deduct the entire amount as an ordinary and necessary business expense.
If you have an applicable financial statement, then you may increase the per item or per invoice amount up to $5,000.
In determining whether the cost of an item exceeds the $2,500 or $5,000 threshold, you must include all additional costs that are on the same invoice with the tangible property—for example, delivery and/or installation fees.
Also, you can’t break into separate components property that you would normally buy as a single unit.
Example. Alex buys a desk for her office for $3,000. She tells the store to separately bill her $250 for each of the four desk drawers and $2,000 for the rest of the desk. Because a desk usually includes drawers as part of a single unit, the IRS adds the cost of each component to determine that the actual cost is $3,000. So, the desk doesn’t qualify for the de minimis safe harbor.
To qualify for this de minimis expensing safe harbor, a taxpayer must:
If you have an “applicable financial statement” and wish to qualify to use the $5,000 de minimis limit, your accounting procedure must be in writing and signed before January 1 of the tax year. If you don’t have such a statement and qualify only for the $2,500 limit, you don’t need to put your procedure in writing (although you still may do so). But it should still be in place before January 1 of the tax year.
To take advantage of the de minimis safe harbor, you must file an election with your tax return each year. When you make this election, it applies to all expenses you incur that qualify for the de minimis safe harbor. You can’t pick and choose which items you want to include. You must also include items that would otherwise be deductible as materials and supplies.
Find out about IRS audit rates and the odds of being audited in What Are the Triggers of IRS Tax Audits?
Learn how much time most people spend doing business taxes.
Read about common tax deductions for individuals.
For more information on this and other tax issues for small businesses, get Deduct It! Lower Your Small Business Taxes, by Stephen Fishman (Nolo).
If you need more help, talk to a tax professional, such as a certified public accountant or a tax attorney. A tax professional can prepare tax returns or provide tax information, guidance, or representation before the IRS.
]]>The cost of such items may be deducted in the year the item is used or consumed in your business—which may be later than the year purchased. To use this deduction, you are supposed to keep records of when such items are used or consumed in your business.
Any item of tangible personal property you buy to use in your business that is not inventory and that costs $200 or less is currently deductible as materials and supplies. The cost may be deducted in the year the item is used or consumed.
Example: Acme, Inc., a billing company, purchases 10 scanners for use by its employees at a cost of $150 a piece. Acme’s employees immediately begin using five of the scanners and Acme stores the remaining five machines for later use. Since each machine cost less than $200, they are materials and supplies and Acme may deduct each machine’s cost when it begins using it in its business: five machines for the year of purchase and five machines for later years when the company begins using them.
“Incidental” materials and supplies are personal property items that are carried on hand and for which no record of consumption is kept or for which beginning and ending inventories are not taken. In other words, these are inexpensive items not worth keeping track of. Costs of incidental materials and supplies are deductible in the year they are paid for, not when the items are used or consumed in the business.
Example: John, a professional writer, purchases two packs of pens and three boxes of paper clips he plans to use for his writing activity over the next two years. The cost was minimal and he does not keep inventory of each pen or paperclip. These are incidental compared to his business and deductible in the year he paid for them.
If your business was in existence before 2014 and you didn’t have a policy in place of currently deducting items that qualify as materials and supplies that exactly matched the requirements of the new IRS regulations (which you likely didn’t), your adoption of the rule in 2014 and later is considered to be a change in your method of accounting. Ordinarily, you must obtain IRS permission for such a change by filing IRS Form 3115, Application for Change in Accounting Method. Unfortunately, IRS Form 3115 is an extraordinarily complex form that few taxpayers will be able to file without the help of a knowledgeable tax professional.
However, the IRS has enacted special optional relief from this requirement for “smaller” taxpayers. This includes all taxpayers with (1) assets under $10 million (as of the first day of the tax year) or (2) less than $10 million in annual gross receipts for each distinct business they own. Under IRS Revenue Procedure 2015-20, such taxpayers may elect to apply the materials and supplies deduction in 2014 and later without filing Form 3115 or making any other filing. You simply treat such expenses as deductible materials and supplies in your books and records. By electing this relief, a taxpayer does not apply any part of the IRS repair regulations (of which the materials and supplies deduction is a part) to years before 2014. This may or may not be advantageous, and is a matter to discuss with your tax professional.
The IRS regulations also contain a new de minimis safe harbor that permits business owners to deduct tangible personal property that costs no more than $500 (or more for larger businesses that have certified financial statements). If you elect to use the de minimis safe harbor, you must apply it to amounts paid for all materials and supplies that meet the requirements for deduction under the safe harbor. (IRS Reg. §1.263(a)-1(f)(3)(ii).) Thus, if you use the de minimis safe harbor, you can largely ignore the materials and supplies deduction. This is to your advantage since the $500 de minimis safe harbor for most businesses is larger than the $200 materials and supplies limit. Moreover, the de minimis safe harbor permits you to deduct the cost of items the year they are purchased, instead of when they are actually used or consumed in your business.
One exception where the materials and supplies deduction could prove useful, even where a de minimis safe harbor election is made, is for components used to repair property. If the components cost more than $500, the de minims safe harbor can’t be used. But the materials and supplies deduction can be used, no matter how much the components cost. The deduction may be taken in the year when the components are actually used in the course of a repair or maintenance.
]]>The safe harbor for small taxpayers (SHST; IRS Reg. §1.263(a)-3h) took effect at the start of 2014. If you qualify to use it, you may currently deduct on Schedule E all your annual expenses for repairs, maintenance, improvements, and other costs for business real property, including rental property owned by landlords. However, there are significant restrictions on who may use this safe harbor.
To take advantage of this safe harbor, landlords need to keep careful track of all their annual expenses for repairs, maintenance, improvements and similar items--something they should be doing anyway.
As the name implies, the SHST is intended to be used by business owners with relatively small businesses. Thus, there are strict limits on the value of buildings that may qualify under the safe harbor, and on the annual amounts the building owners can spend and earn. You cannot use this safe harbor in any year any of these limits are exceeded. But, so long as you come within these limits, you may use the SHST for any number of rental buildings or units—you are not limited to just one.
The SHST may be used only for buildings—including condos and coops--with an unadjusted basis of $1 million or less. Thus, it can’t be used for many larger apartment buildings or other more expensive rental buildings. “Unadjusted basis” usually means a building’s original cost (also called its cost basis), not including the cost of the land.
To determine a building’s unadjusted basis, you don’t subtract the annual amounts you deduct for depreciation. But you add the value of any improvements you make to the building while you own it and that you are depreciating along with the rest of the building.
If you own more than one rental unit or building, the $1 million limit is applied to each separately. Thus, for example, a landlord with 10 rental buildings each with an unadjusted basis of less than $1 million could use the SHST for each of them.
A landlord may use the SHST only if the total amount paid during the year for repairs, maintenance, improvements, and similar expenses for a building does not exceed 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.
The 2% of the adjusted basis rule means that a building with basis of greater than $500,000, but not more than $1,000,000, will still have the $10,000 annual limit.
The limit is applied on a per building basis. Thus, if you own two or more rental buildings, you may be able to use the SHST for some, but not others.
Finally, to qualify for the SHST a landlord must have average annual gross receipts of no more than $10 million during the three preceding tax years. Gross receipts include income from sales (unreduced by cost of goods), services, and investments. This poses no problem for smaller landlords.
The small taxpayer safe harbor must be claimed anew each year by filing an election with your timely filed tax return, which is due by October 15 each year (if you obtain an extension of time to file). Thus, you can use the SHST for amounts paid during 2014 by filing the election with your 2014 tax return, which must be filed no later than October 15, 2015 (if you obtain an extension of time to file).
You can claim the SHST for some years and refrain from doing so for other years—it’s entirely up to you. The SHST is also claimed on a building-by-building basis. Thus, if you own more than one rental building, you can claim the SHST for some rental buildings and not use it for others.
There is no IRS form for this election. However, it is a very simple document you can easily create yourself and attach to your return. If the rental property covered by the SHST is owned by a partnership, limited liability company, or S corporation, the election must be made by the business entity, not by the individual partners, LLC members, corporate shareholders. Once this annual election is made, it may not be revoked for the year it covers.
Sam owns a single family home that he rents out. It has a $100,000 unadjusted basis (that is, it cost $100,000). During 2014, he paid $200 to a plumber to fix a leak, repaired a window for $400, and replaced the home’s water heater for $1,200. Sam qualifies for the small taxpayer safe harbor because the $1,800 he spent on repairs, improvements, and maintenance during 2014 is less than 2% of his building’s unadjusted basis (2% x $100,0000 = $2,000). By filing an election to use the SHST, Sam may currently deduct the entire $1,800 on his 2014 IRS Schedule E. This is so whether or not any of these expenses, such as the water heater replacement, might constitute an improvement under the more complicated IRS repair rules that apply in the absence of a safe harbor. (See IRS Finalizes Rules on Repairs Versus Improvements for more information.)
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