Rental Property Tax Deductions

As the proud owner of rental property, there’s a good chance that you know about and are already using one of the most well-known and popular tax deductions available to landlords:

Repairs are a much-loved deduction, and for many landlords, they represent a significant saving come tax time. They’re popular thanks to their value, as well as the fact that they’re a tangible expense. It’s easy to remember these expenses when you’re doing taxes, and not too difficult to save the receipts throughout the year –especially if you’re organized.

But while this deduction is indeed popular, some landlords aren’t aware that not every repair should be treated the same. While some are able to be fully deducted in the year that they’re incurred, for others, how they’re able to be deducted will vary depending on a few different factors.

The main difference in how these expenditures are treated comes down to one important distinction: is it a repair, or is it an improvement? The IRS also outlines several “safe harbors,” as they call them, under which you can fully deduct many repairs that would otherwise have to be depreciated more slowly over time.

Although making sense of the different distinctions and nuances of the IRS’ guidelines can get a bit complicated, in this guide, we’ll attempt to uncover the main points for classifying and deducting repairs and improvement expenses for your rental.

Property Management Repairs vs. Improvements

While rental repairs and improvements are both able to be deducted, the IRS has different rules regarding how they must be claimed.

Repairs are operating expenses that are deemed ordinary, necessary, and reasonable in amount. As long as they meet these requirements, they’re able to be fully deducted in the year that they’re incurred.

However, certain types of upkeep aren’t considered to be repairs; but instead, need to be classified as capital improvements. Improvements are things that add value to your property or benefit your property for more than one year.

Since the benefit to your property will extend beyond one year, they cannot be depreciated in just a single year, but instead must be spread out over the course of a longer period of time and claimed a little at a time on your tax return each year.

In most cases, you’re better off from a tax point of view if you can classify an expense as a repair, rather than an improvement, as you’ll be able to deduct the entire expense all at once instead of having to slowly deduct it over a long period of time. Of course, this doesn’t mean that you should never do improvements on your property, only that from a tax perspective, repairs offer more benefits.

Now, how can you tell the difference between repairs and improvements?

The IRS’ regulations spell out rules for what constitutes a repair and what is considered an improvement. This guide is fairly long, however, and quite complicated as well.

Still, generally speaking, the IRS uses the following categories to define what qualifies as a capital expense.

According to the IRS, expenses that fall under these categories must be depreciated as a rental property tax deduction.

• Improvements: You must capitalize any expense you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use.
• Betterments: Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property.
• Restoration: Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.
• Adaptation: Expenses that may be for adaptation include expenses for altering your property to a use that isn’t consistent with the intended ordinary use of your property when you began renting the property.

Here’s a look at some examples of improvements from the IRS:

Additions:

• Bedroom
• Bathroom
• Deck
• Garage
• Porch
• Patio

Lawn & Grounds:

• Driveway
• Walkway
• Fence
• Retaining wal
• Sprinkler system
• Swimming pool

Miscellaneous:

• Storm windows, doors
• New roof
• Central vacuum
• Wiring upgrades
• Satellite dish
• Security system

Heating & Air Conditioning:

• Heating system
• Central air conditioning
• Furnace
• Duct work
• Central humidifier
• Filtration system

Plumbing:

• Septic system
• Water heater
• Soft water system
• Filtration system

Interior Improvements

• Built-in appliances
• Kitchen modernization
• Flooring
• Wall-to-wall carpeting

Insulation

• Attic
• Walls, floor
• Pipes, duct work

Three Safe Harbors

For most landlords, being able to deduct expenses all at once in the year that they were incurred is always preferable; and better than having to depreciate them.

Thankfully, the IRS provides what’s known as “safe harbors” –conditions that landlords can use to deduct certain rental-related expenses –in one year.

Here’s a look at these three safe harbors now:

• The small taxpayer safe harbor
• The routine maintenance safe harbor
• The de minimus safe harbor

If an expense falls under any of the safe harbors, then it can be treated as a currently deductible expense and deducted entirely in the year that it occurs.

In short, these safe harbors make life easier and allow you to deduct expenses that otherwise would have to be depreciated.

In order to determine whether an expense qualifies as a deduction, first, determine whether it falls under one of the safe harbor provisions. Secondly, if no safe harbors apply, you’ll then want to determine whether the expense is a deductible repair or an improvement.

With this in mind, here’s a look at the three safe harbors now:

1. Safe Harbor for Small Taxpayers (SHST):The safe harbor for small taxpayers (SHST) could easily rank as one of the most important safe harbors for small landlords. Under this safe harbor, you can deduct all of your annual expenses for your rental –including repairs, maintenance, and improvements –without having to worry about whether or not they qualify as repairs as opposed to improvementsHowever, it’s important to note that there are some important restrictions when it comes to using this safe harbor, and of course, you’ll also need to keep track of all of your expenses throughout the year as well.In order to qualify, the total amount of maintenance, repairs, and improvements that you’ve paid out during the year must total less than $10,000 or 2% of the unadjusted basis of the building –whichever’s less.Additionally, the SHST can only be used for buildings with an unadjusted basis of $1 million or less. Although if you own more than one rental unit or building, the $1 million limit is applied to each separately.Finally, in order to qualify, you must have average annual gross receipts of no more than $10 million during the three preceding tax years.You can learn more about the Safe Harbor for Small Taxpayers in Nolo’s article: Small Taxpayer Safe Harbor For Repairs and Improvements.
2. Routine Maintenance Safe Harbor:Under the routine maintenance safe harbor, expenses that qualify as routine maintenance are deductible in a single year. With this safe harbor, there are no dollar limits and any landlord can use it, regardless of the amount spent on maintenance. However, there are a few limits on when this safe harbor can be used.
   1. Take a look: Routine maintenance is recurring work done to keep a building in operating condition, and includes two activities:
      • 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.

      There are two main limitations on routine maintenance: the ten-year rule and the no betterments rule.

   2. The Ten-Year Rule - Maintenance qualifies for the routine maintenance safe harbor only if, when you placed the building or building system into service, you expected to perform this maintenance more frequently than once every ten years.
   3. No Betterments or Restorations - This safe harbor is intended for expenses incurred to keep the property in operating condition, but it does not apply to major remodeling projects. Additionally, you can’t use this safe harbor when you’ve taken a casualty loss.
3. De Minimis Safe Harbor - Finally, there’s also the de minimis safe harbor. With this option, landlords can deduct any low-cost personal property items used in their rental business. In most cases, the maximum amount is $2,500 per item. All expenses you deduct using the de minimis safe harbor must be counted toward the annual limit; the lesser of 2% of the rental’s cost or $10,000.

Rental Property Repairs vs Improvements

If your expenses don’t fall under a safe harbor, then you’ll need to determine whether they are improvements or repairs. While repairs can be deducted in one year, improvements must be depreciated and deducted over several years.

In order to determine whether it’s a repair or improvement, you’ll need to delve into the IRS’ repair regulations and determine what the unit of property (UOP) in question is. You’ll then want to decide whether the expense resulted in an improvement.

Under IRS regulations, buildings must be divided up into nine different UOPs.

Here’s a look at them now:

1. Building Structure
2. Heating, ventilation, and air conditioning (HVAC) systems
3. Plumbing systems
4. Electrical systems
5. Escalators
6. Elevators
7. Fire-protection and alarm systems.
8. Security systems
9. Gas distribution system

Generally speaking, the larger the UOP, the more likely the work will be considered a repair, rather than an improvement.

Joseph Lewis, CPA and Partner at Isler CPA explains this concept well in his article: Rental Property Repairs: to Expense or to Capitalize? That Is the Question. “Work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.”

Any work done to any of the above building systems that improves that system in some way must be depreciated.

Deducting Repairs and Maintenance

Repairs and maintenance are different things, but you’ll want to deduct both of them on IRS Schedule E. You’re required to list each type of expense separately, so try to keep track of them throughout the year as well.

At the end of the day, landlords benefit more from a tax perspective by taking advantage of the safe harbors, or making repairs; rather than upgrades. While upgrades can be a necessary part of owning a rental, it’s always a good idea to consider the long-term tax implications when deciding whether to repair or replace an item.

Additional Resources

Here are some additional resources on rental property tax deductions and repairs and improvements.

• IRS – Form 1040 Schedule E Instructions
• IRS – Form 1040 Schedule E Instructions
• IRS – A Brief Overview of Depreciation
• IRS Publication 946 – How to Depreciate a Property
• Nolo: Every Landlord’s Tax Deduction Guide

Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.