Rental properties require regular repairs and maintenance, and occasional rehabilitation. It can be confusing to determine how these costs will be treated for income tax purposes. That’s what we’re here for! Let us provide you a brief overview of the tax concepts a property owner should be aware of when considering the tax impact of such costs.
BAR – BETTERMENT, ADAPTATION, RESTORATION
For many years, there was little guidance from the Internal Revenue Service (IRS) on whether a repair must be capitalized or expensed. That changed when the IRS issued Treasury Decision 9636, commonly referred to as the Tangible Property Regulations, on September 17, 2013. These new rules provided a logical framework for determining if an expenditure must be capitalized. If an expenditure can be described as a Betterment, Adaptation, or Restoration, it must be capitalized and depreciated. If an expenditure cannot be described in that manner, it can be expensed.
What is a Betterment?
An expenditure that results in an asset having improved functionality or corrects a defect that existed before the asset was purchased. For example, enlarging the square footage of a building.
What is an Adaption?
An expenditure that results in an asset having a new or different purpose. For example, a warehouse space that is converted to a residential property.
What is a Restoration?
An expenditure that is needed to make an asset usable again after it has fallen into disrepair. For example, gutting and rebuilding a condemned structure.
USEFUL TAX ELECTIONS
To reduce the time and hassle of complying with the BAR rules, two safe harbor elections were made available to taxpayers.
De Minimis Election
This election was created in conjunction with the Tangible Property Regulations. If a taxpayer makes this election, any expenditure on one item that costs $2,500 or less can be expensed, regardless of the BAR rules. The amount is increased to $5,000 for taxpayers that have financial statements audited by a CPA. For example, if a sink was replaced for $300; it can be expensed.
Small Taxpayer Safe-Harbor Election
This election was created by the issuance of Reg. Sec. 1.263(a)-3(h) in 2014. This election is made for an individual property rather than a blanket election on a tax return. To qualify, a taxpayer must meet the following criteria:
- Gross receipts of $10,000,000 or less.
- The unadjusted basis (original cost) of the property must be $1,000,000 or less.
- The total of repairs, maintenance, and improvements made in the relevant year must not exceed the lesser of $10,000 or 2% of the unadjusted basis (original cost) of the property.
If all these criteria are met, then expenditures may be expensed regardless of the BAR rules. For example, all the carpeting in a rental house was replaced for $5,000; it can be expensed.
Expenditures that must be capitalized are depreciated over different lengths of time. Generally, that period is 39 years for a commercial property, and 27.5 years for a residential property. However, there are expenditures that qualify for shorter lives. Land improvements, such as parking lots, fencing, or sidewalks, have a 15-year life. Appliances and tacked down carpet have a 5-year life. There are numerous other exceptions.
Under the current tax law, a taxpayer may take 100% bonus depreciation on qualified assets. This allows a taxpayer to effectively write off an expenditure even though it had to be capitalized. Generally, any asset with a depreciable life of 20 years or less is eligible for bonus depreciation. For example, a parking lot with a 15-year life is eligible for bonus depreciation, which means it can be fully written off in the year it was completed.
Similar in concept to bonus depreciation, Section 179 allows taxpayers to write off assets that they were forced to capitalized. Unfortunately, Section 179 is rather confusing in the context of rental properties, as it makes a distinction between commercial and residential rentals.
For commercial rental property, a taxpayer may use Section 179 to write off roofs, HVAC, fire protection systems, security systems, and some interior improvements. Section 179 is not available for expenditures related to elevators, structural improvements, enlargement of square footage, or the exterior of a building unless otherwise noted.
For residential rental property, Section 179 is far more limited. It can only be used to write off appliances, furniture, or other personal property.
It is important to note that Section 179 can only be used to the extent a taxpayer has net income. In other words, it cannot cause a taxpayer to have negative net income. This can complicate tax planning for taxpayers with multiple revenue streams.
The rules surrounding this topic are complex and change frequently. There are many things to consider in addition to the points enumerated in this article. Please consult your tax advisor before drawing any conclusions on how your expenditures will be viewed by the IRS. Please feel free to reach out to our firm, ADKF, for consultation on this or any other tax matter.