Repair vs. Improvement: When Can You Deduct It?

A rental property owner faces a $27,000 repair bill after a plumbing leak forces a complete bathroom renovation, water heater replacement, and structural repairs. Jeremy breaks down Treasury Decision 9636's framework for distinguishing between deductible repairs and capitalized improvements, using the three-part test of betterment, restoration, and adaptation. He also explains three valuable safe harbors including the de minimis election and routine maintenance provisions that can help property owners expense more costs immediately rather than depreciating them over time.

Sponsors
SafeSend - taxshow.promo/safesend

• (00:00) - Introduction to Repairs vs. Improvements
• (00:44) - Understanding the Basics of Repairs and Improvements
• (01:42) - Real Estate and Vehicle Examples
• (04:30) - IRS Guidelines and Treasury Decision 96-36
• (06:53) - Case Study: Rental Property Repairs
• (18:39) - Determining Repairs vs. Improvements
• (39:05) - Safe Harbors for Taxpayers
• (55:57) - Conclusion and Key Takeaways

Connect with Jeremy
https://www.linkedin.com/in/jwellstax
https://www.steadfastbookkeeping.com

Subscribe on YouTube
https://www.youtube.com/@TaxinAction

Earn CPE for Listening to This Podcast
https://www.earmark.app/

This podcast is a production of the Earmark Media

Creators and Guests

Host

Jeremy Wells, EA, CPA

COO and Head of Tax at Steadfast Bookkeeping

What is Tax in Action: Practical Strategies for Tax Pros?

Join Jeremy Wells, EA, CPA, as he breaks down the complexities of tax law into practical guidance you can apply immediately. Each episode focuses on a specific tax strategy, credit, or compliance issue that matters to tax professionals and business owners. Rather than theoretical discussions, Jeremy delivers actionable insights based on real-world scenarios and current tax regulations. Whether you're navigating Section 1031 exchanges, maximizing research credits, or helping clients with energy tax incentives, this podcast provides the technical details and strategic considerations you need to confidently serve your clients. Perfect for tax practitioners looking to deepen their expertise and business owners wanting to make more informed tax decisions.

There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.

Jeremy Wells: Welcome to another episode of Tax in Action. So every now and then you come across a case where you need to repair, or maybe you want to improve something. This is especially true for a rental property owners, maybe true of owners of other kind of property cars. For example, [00:00:30] anytime you have some sort of asset that has either been damaged or just due to normal wear and tear, you need to fix it up a little bit. You need to get it back into proper working order. You're going to have to spend some money on that, and taxpayers will always want to try to deduct as much of what they have to spend as possible. But sometimes the amounts that you pay, or the kinds of things that you're paying for to restore, repair, improve, [00:01:00] upgrade that asset. Sometimes accounting rules and tax law make it to where we can't just immediately deduct all of those costs. We need to treat it as some sort of improvement to that property instead of just a repair. The question often comes up where do we draw the line? What distinguishes a repair from an improvement? Or another way to think about [00:01:30] this might be what distinguishes just normal operating maintenance from actually restoring or upgrading or improving that asset. I bring up real estate and cars. These are the two probably most common examples of this. You're driving a car around. This is your business vehicle. You're meeting clients with that vehicle, or you're making deliveries with that vehicle or you're picking up supplies with it.

Jeremy Wells: And over time, [00:02:00] that vehicle will wear down. And at some point you'll need to do some pretty significant maintenance to it, more than just the normal putting gas in the tank or getting the oil changed. Maybe you need to replace a part of that vehicle. Maybe you need to replace some part of the engine, or maybe the entire engine. Maybe the transmission. At what point are you no longer just maintaining that vehicle? Are you actually making a significant change to that vehicle? And real [00:02:30] estate, especially real estate, is very interesting in terms of this repair versus improvement discussion. Think about when you have a room of a rental property that's got a lot of activity in it, like a kitchen or a bathroom, and over time, the fixtures in that room, they either wear out or most [00:03:00] likely they go out of date. Styles are changing all the time. If you're one of those who likes to look at properties on Zillow, one of the first things you're going to look at when you're looking at a new property is whether the style of the fixtures even matches your style. And a lot of times that has to do with whether it looks dated or not. If that house hasn't been updated since it was built 20, 30, 40 years ago, it's probably going to need some work. And if you're trying [00:03:30] to rent that property, you're definitely going to want to get in there and replace some of those old fixtures.

Jeremy Wells: Worn out fixtures, outdated fixtures to make it look appealing to potential tenants. When do we draw the line between just doing some minor repairs, maintenance versus we're actually improving the property. We're upgrading it. That's the topic of this episode is when can we deduct these [00:04:00] expenses as repairs versus when do we need to capitalize them as improvements? That's really the two options we have whenever we spend money on an asset in order to fix it up or make it working again, or improve it so that it's more appealing to potential users, or that it just looks in style for today's fashion. So this is an [00:04:30] issue that's been around for quite a while, and I'm going to talk about the IRS's attempt to really draw a line in the sand and clarify, when do we need to capitalize the cost of those improvements, versus when can we just expense those costs as just normal repairs and maintenance. This is going to come through in a particular document that was actually a collection of [00:05:00] several new regulations, Treasury regulations, all put together into one document called a Treasury decision, Treasury decision 9636, that really, uh, put together several different regulations and took some proposed and temporary regulations and finalized them into a set of rules, really a framework or a set of guidelines on [00:05:30] how to make this decision between when to deduct those expenses as repairs versus when to capitalize them as improvements.

Jeremy Wells: It's not a clear cut discussion. A lot of times, however, what this Treasury decision does is it gives us this framework for being able to think about the difference between the two. Being able to distinguish a certain kind of expense or expenditure between those two. And then it also includes a few, what [00:06:00] we call safe harbors. Safe harbors are essentially a way to help taxpayers out by simplifying things down a little bit. There's an old saying that in tax law, there's the rule, there's the exception to the rule, and then there's the exception to the exception here. If we want to think about it, the rule is we usually have to capitalize improvements. The exception to that is if it's not an improvement then it might [00:06:30] be a deductible repair. And then the exception to all of that is that even if it really should be capitalized as an improvement, there are some cases where you can still just go ahead and deduct it as a repair. So we're going to talk about all that and break all that down. But in order to illustrate this, let's think about an example. Let's take a taxpayer that owns and and operates a two story residential rental property. [00:07:00] This is actually a case that I dealt with a couple years ago in my own firm. So it's a two story residential rental, single, uh, single family residential rental.

Jeremy Wells: And the tenant reported to the owner a leak in the first floor ceiling. They're essentially just sitting in the living room. And notice that the ceiling above them is starting to leak. And on the other side of that ceiling is the upstairs bathroom. So [00:07:30] the owner calls a plumber. The plumber comes over, looks at the bathroom, gets into the plumbing, recognizes that the plumbing is pretty old, there's some corrosion, there's some damage, seals, loose connections, and all of that is causing this leak. Given the extent of the damage, uh, and all the repairs that are going to need to happen and the condition and the age of all of the fixtures in that bathroom. The owner of the rental decides to just go ahead and [00:08:00] take this opportunity while the tenants have to be out of the rental anyway. And a lot's going to have to go into these repairs. The owner decides to just go ahead and renovate the entire bathroom. So not just fix the plumbing, but also replace all of the bathroom fixtures and really upgrade this bathroom. Now the plumber also at the same time recommended replacing the water heater. This is, uh, one of those things that can happen not that [00:08:30] frequently, but every few years. Uh, depending on the usage, a water heater can just break down. Uh, and so it's one of these things that at any point really, uh, like a lot of small appliances in the home.

Jeremy Wells: All of a sudden, one day it just stops working. And you can either wait until that or if you notice that the condition is already, uh, tending in that direction, or if the age is already at a certain point [00:09:00] to where maybe it's time to go ahead and proactively replace, uh, that fixture or that system, then it's a good idea to go ahead and do so. So again, while the tenants are out, while all these repairs need to happen, the owner agrees to go ahead and replace the water heater, uh, in the house as well, due to its age and condition based on the plumber's recommendation. So now the costs of all this come in. The plumbing repairs totaled about $4,000. The [00:09:30] bathroom renovation is actually replacing all the fixtures, the flooring, all of that totaled about $16,000. The new water heater and installation of that cost about $4,000. And then repairing the upstairs floor and the downstairs ceiling cost about $3,000. So it was a pretty significant amount of money that had to go into these repairs and restorations, as a taxpayer was really not planning on spending. And so given that [00:10:00] sudden, unexpected expense, the taxpayer is kind of short on cash and really wants to deduct as much of this as possible. So we need to think about out of these four different types of costs that happened here, the plumbing repairs, the bathroom renovation, the water heater replacement and then repairing the floor and the ceiling from the damage from the leak.

Jeremy Wells: What [00:10:30] of this, if any, can we deduct? And whatever we can't deduct, we're going to have to capitalize. So again we're going to look at these repair regulations. And that's what they commonly go go by. Either that or the tangible property regulations. And this all comes from a document called Treasury Decision 9636. [00:11:00] You can just pull up this document and read through it. And it's actually helpful to do that. Now a lot of times I don't reference Treasury decisions, but that's the format in which the Treasury Department releases new, uh, permanent or what we call final Treasury regulations. They come out in a document called a Treasury decision. And the reason going to the Treasury decision document can be helpful, [00:11:30] as opposed to going directly to the Treasury regulations, is that the Treasury decision document will include what's called the preamble and the preamble, depending on how much, uh, how many regulations are involved in this Treasury decision, and depending on the topic, the preamble can be anywhere from a page or two to, in the case of this Treasury decision, about 60 pages of explanation and a little bit [00:12:00] of history of how we got to where we did with the regulations that are in this decision, it can be really helpful to read through this to understand how tax law treated the particular topic or subject before these final regulations were adopted, and to look at how Treasury decided, uh, on which way to go on some of these regulations, all of these regulations are a, [00:12:30] uh, are choice.

Jeremy Wells: The Treasury Department is actually making a choice as to how it's going to decide to treat certain kinds of transactions or certain kinds of assets, for example. It can be helpful to understand why the Treasury Department made the decisions that it did. How would that help? Because oftentimes you get [00:13:00] some examples or some explanations of how Treasury decided that isn't particularly clear from the regulation itself. In this case, what we get out of this Treasury decision is an explanation of what the law was before these regulations, the temporary and proposed regulations that came around in the years leading up to these final regulations. And then [00:13:30] we also get some of the an explanation of the comments that Treasury Department received with respect to those proposed regulations. In a future episode, I'm going to talk about how we get these Treasury regulations and where they fit within tax law. But in general, when the Treasury Department wants to issue regulations on a particular topic, it [00:14:00] will first issue what's called proposed regulations. And then there's a certain time period during which the general public has a chance to comment on the text of those proposed regulations. And when you read through that, you get an idea. Now this is all summarized, but you get an idea of what topics get a lot of attention from the general public, and where the general public has an influence on how these regulations are actually determined.

Jeremy Wells: And it can [00:14:30] be interesting to see some of that history. Now, that preamble material doesn't actually have any legal effect. You can't point to the preamble and say, well, it says this in the preamble. Therefore, legally, I can do this or that. It doesn't actually it's not actually part of tax law. But what it does is it helps you understand how the tax law and the regulations got to where they are today. Like I said, there's about 60 something pages [00:15:00] in the preamble to these regulations. So it's quite a lot of material there to go through thinking about how we get these regulations. And in particular what happens in this Treasury decision is the Treasury Department says there are two different code sections that they don't necessarily contradict each other, but there's a gap between them. So on one hand we have section 162, 62, which [00:15:30] is the one of those sections that if you work in tax, especially if you work with business owners, you just have to know what 162 is. 162 tells us that business expenses are deductible if they are ordinary and necessary. That's that's the gist of section 162. Obviously, there's a lot more to it than that, but that's that's the gist. If we want to know if a certain type of expense is ordinary or necessary, and if it's therefore deductible by a business, we're going to go to section [00:16:00] 162.

Jeremy Wells: And we're going to look at the Treasury regulations that are associated with that code section. Now there's that. And Treasury Regulation section 1.1624 discusses repairs. And it's actually a relatively pretty short Treasury regulation. It basically says repairs that are ordinary necessary are deductible. Okay. Then we also have section 263. Section 263 tells us that we have to capitalize [00:16:30] amounts that are paid to acquire, produce, or improve tangible property. Then there are some regulations associated with section 263 and what those regulations do. And this is primarily what's happening in this Treasury decision is they clarify when we are repairing property versus improving that property. So in other words, when we get to deduct those costs versus [00:17:00] when we have to capitalize them because it's not clear. Just looking at the code sections, one code section tells us that we can deduct the cost of repairs. Another code section tells us that we have to capitalize the cost paid to acquire produce or improve property. And so there's still this question of when are we repairing property versus when are we improving it? If I need to replace the engine in my car because it's worn out, Is that just a normal, ordinary repair, or have I actually improved that vehicle? [00:17:30] Because I probably added a lot of value and I've extended the useful life of that vehicle. Plus, that was just a pretty significant expenditure too.

Jeremy Wells: And a lot of times when we spend a lot of money like that in account, both accounting and tax, we question whether we can just deduct that amount without having to capitalize it. So with this Treasury decision and the regulations that are finalized in it, do is help us, give us this framework to be able to make [00:18:00] that determination. Now, if an expenditure is an improvement to the property, then it has to be capitalized generally. Otherwise if it's a repair it can be expense. This is pretty much what I've been saying. And again that discussion of repairs is in Treasury Regulation 1.1624. But in order to determine whether we need to treat that expenditure [00:18:30] as an improvement and capitalize it, we have to decide what we actually mean by improvement as opposed to just repairs. What these regulations give us, and this Treasury decision is a two part test to determine if what we have is actually an improvement. The first thing we have to do is determine the unit of property. The unit of property is the actual asset really that [00:19:00] we are either replacing or repairing or improving. So again, if we think about a vehicle and I have to replace the engine is the unit of property the engine. Is it the entire vehicle? The unit of property is usually the asset that we would consider the asset of that of that business, right? What would we actually see listed on a balance sheet or depreciation [00:19:30] schedule? For example, we're typically not depreciating an engine separately from the vehicle that it's in.

Jeremy Wells: So for purposes of thinking about the unit of property, we really need to think about, you know, what what is it that we're actually repairing or improving. We're not just repairing an engine when we replace it, we're actually repairing or improving the entire vehicle. Now for [00:20:00] a building, if we're talking about a rental property, it's a little bit more complicated than that because the different components of a building, on one hand, they all need each other in order to function as a, as an independent building. But on the other hand, some of the different systems and structures within a building honestly can operate fairly independently. Um, and so [00:20:30] particularly with respect to a building, we get a breakdown between the structure and what's called the building systems. The building structure includes the building itself. So the actual material that that building is, is made out of, along with the doors, the walls, windows, partitions, floor ceilings and any permanent covering such as tiling or brick. So whatever that structure [00:21:00] is actually made out of, and then all of those parts of the structure that we would consider permanent parts of that structure. So, so again, the doors, the walls, the windows, things like that, the systems are all of those different parts of that structure that make it functional. This includes the heating, ventilation and air conditioning or the HVAC, the plumbing system, the electrical system, elevators, escalators, the [00:21:30] fire protection and water sprinkler systems, the gas distribution system.

Jeremy Wells: If there's natural gas in that building, and then the security system, those are specifically listed out in the regulations as the key systems of a building. As we go through thinking about the repairs and restorations that needs to happen with this rental property, we have to distinguish between what is happening [00:22:00] with the structure of this building versus what's happening with the specific systems. Because there's a difference in a building between having to repair the structure of that building versus having to repair or replace one of the systems. Of that building. For example, in this case, because we're talking about a plumbing leak. We're going to talk about the plumbing system, and we're going to talk about that separately. From [00:22:30] the actual structure of the building, such as the second story floor and the first floor. Ceiling. Uh, and so thinking about these separately is going to be necessary for how we determine whether we're talking about repairs versus improvements. So in this case one unit of property is going to be the actual structure. We're talking about the second story floor and the first story ceiling. Another unit of property though is going to be the plumbing system. [00:23:00] Now once we determine that unit of property then we have to determine if the expenditure is on an improvement to that unit of property. So the expenditure is an improvement if it produces one of the following three results.

Jeremy Wells: Again, we don't get from section 263 of the code what we actually mean by an improvement. So what the regulations are going to do is clarify that for us. [00:23:30] And in the regulations, Treasury Department gives us three different ways of thinking about what an improvement would do to a piece of property. So that improvement can either produce a betterment of that unit of property, a restoration of the unit of property, or an adaptation of that unit of property. So let's go through these one at a time. So a betterment to a unit of property includes. Now this [00:24:00] is broken down into three different concepts. What do we mean by bettering a unit of property. It's an amelioration of a condition or defect that existed prior to acquisition or arose during production. So just think about the engine in the car that needs to be replaced. There is something in that engine that's not quite working right. And that's [00:24:30] causing a problem for the operation of that vehicle. So we need to either significantly repair or replace that engine. If we do that, then we have ameliorated the condition or the defect that is is affecting the operation of that vehicle. That would be a type of betterment of that vehicle. Another type of betterment is an addition such [00:25:00] as an enlargement, expansion, extension, addition of a major component or an increase in capacity. This is usually what happens with real estate when we talk about adding on, say, an extra bedroom or adding on a spare room, adding on some, uh, sort of, uh, sunroom is something that happens a lot down here in Florida.

Jeremy Wells: Uh, a lot of people have paved patios right outside the back door. [00:25:30] They'll want to turn that into some usable space that doesn't have the the heat and the direct sunlight and the bugs and all that kind of stuff. And so they will wall that in and create a sunroom. That would be an addition to the home that betters the home. It's a betterment to that property and therefore it improves the property. And then another type of betterment is a change that's reasonably expected to increase [00:26:00] the productivity, efficiency, strength, quality or output of the unit of property. Again, back to the car example. What if instead of the engine having some defect to it, and so we have to replace it? What if instead we just replace the old engine with a new souped up engine that gave the car a lot better performance? It could reach higher speeds. Uh, you know, just any sort of way that we have improved the efficiency or the quality of that [00:26:30] vehicle, that would be a betterment to that vehicle. And so therefore it would be an improvement. Then there's restorations and there are actually six different kinds of restorations. I'm not going to go through all of them here.

Jeremy Wells: Uh, but in general, think about there is some piece of property and it has either been damaged or it's just worn out over time to the point to where it's not just not [00:27:00] running quite the way it used to, but it's actually now become basically either nonfunctional or just unusable. And we want to get that back to a state of being used like it was originally. And in terms of damage, we're reversing the effect of that damage to the point to where it's now operating the way it did before that damage. That's essentially what we mean by restoration. Restoration is especially important, especially for real estate. Thinking in [00:27:30] terms of areas that have just been hit by some sort of natural disaster, such as hurricanes or tornadoes. So if you own a piece of real estate and a tornado comes through and it rips the roof off, or a tree knocks into the house and it takes a wall out, we want to get that property. We're not improving it. We're not making it better. We're not putting an addition onto it. We're just restoring it to the way it was before that storm damage hit it. That, according to these regulations, is [00:28:00] actually a type of improvement. So when we talk about improvement, it improvement. It doesn't necessarily have to be better than it was prior to the condition that brought about that improvement, even just a restoration to the point at which now we're back to the way it was before it got to that condition.

Jeremy Wells: That can be a type of improvement as well. And then finally there's the adaptation. An adaptation of the unit of property gives [00:28:30] it a new or different use that's not consistent with the taxpayer's ordinary use of the property at the time originally placed in service by the taxpayer. This is the case of when we take a particular type of property, and maybe we convert it through actually spending money on it and transforming it into some different kind of property. Uh, with the way [00:29:00] a lot of commercial real estate was hit by the pandemic, uh, with work from home. And so suddenly a lot of commercial property, uh, office space wasn't needed. And so there were attempts to convert some of that office space into apartments, into actual residential space. That is not an easy task. Uh, if you build a building and it's supposed to be offices, usually there's an open floor plan. The [00:29:30] bathrooms don't have what a residential bathroom includes. There usually aren't kitchens. And so converting that space from office space into apartments, that's going to take a significant amount of investment and work to change the layout, to change the structure, to put in all of the facilities that you need for people to actually be able to live in that space. And so that's going to be a significant adaptation of that space from commercial [00:30:00] use to residential use. Um, it's part of why a lot of that actually didn't happen, even though there was a lot of discussion of, why can't we just turn these office spaces into apartments? Well, that would take quite a bit of work, uh, and money, in order to be able to do that.

Jeremy Wells: Uh, and so that adaptation would be a type of improvement of that property. Now, let's think about this, uh, case here where we've got a leak in the upstairs bathroom. The [00:30:30] taxpayer replaced a combination of parts that make up a major component or substantial structural part of that property, and that actually fits one of those six types of restoration. And so in this case, we've restored the plumbing system in this rental property. We have taken those faulty, worn out parts of the plumbing and we've replaced them with new parts [00:31:00] that bring it back up to the level of condition where it should be normally operating. That's a type of restoration, and therefore that would fit the definition of an improvement. Replacing the bathroom fixtures, that would actually be a type of betterment, because there was nothing wrong with the bathroom fixtures before. The problem was in the plumbing. The problem wasn't in the bathroom fixtures themselves, but we are [00:31:30] changing the way those bathroom fixtures look. We're making them, uh, look better. We're making that entire bathroom look better by replacing those fixtures. And so that is a change in the the quality of that unit of property there in, in that, uh, in that bathroom.

Jeremy Wells: And so that would be a betterment, uh, and therefore an improvement. There's no adaptation here. We're. We're not changing the bathroom into something other than that. Uh, so [00:32:00] that's not occurring. But, uh, we do have improvements in terms of the plumbing system as well as the bathroom itself. And then the water heater. Again, we're we're taking a water heater that's not necessarily faulty, but it is, uh, considerably, uh, worn out and aged, at least according to this plumber and his recommendation. And so we're replacing that with a new water heater. Uh, that works [00:32:30] better. And that is a type of restoration and therefore an improvement as well. Now, the cost to repair the upstairs floor and the downstairs ceiling, those are incidental to the restoration of the bathroom. This can be one of those situations where when we're trying to determine the difference between a deductible repair and a capitalized Improvement. It might, uh, it might lead the taxpayer [00:33:00] to think that's a separate thing. It's a repair. I'm calling it a repair. Therefore, it should be deductible. However, there is a particular rule in Treasury regulation 1.2 63A. Uh three G. And this particular rule clarifies what happens when we have these kinds of situations where a lot of these different kinds of expenditures run together. [00:33:30] So you think about what the stack of invoices this taxpayer would have after these repairs and restorations were complete, there would be several different invoices going to all of the different contractors and subcontractors that would have to come in and help with, uh, this problem.

Jeremy Wells: When you've got these kinds of expenses that are all based around the same event. So one of the invoices is coming from the plumber. One [00:34:00] of the invoices is coming from the handy person that had to fix the ceiling in the floor. One of these invoices is coming in for the new fixtures in the bathroom. One of them is coming from somebody else who installed all of those new fixtures. Whenever you have these different costs that are all incidental to the same event, then those costs that directly benefit and result from the improvement have to be capitalized as all part of that improvement as well. [00:34:30] So we can't differentiate between the expenditures that went into fixing the plumbing versus fixing the floor and the ceiling versus improving the bathroom. This is all one project. And so according to that part of the Treasury regulation, we have to consider that all incidental to the improvement, and therefore it's all capitalized if we have to capitalize the cost of this improvement. Now [00:35:00] the water heater is going to be separate from all of that. We didn't replace the taxpayer, didn't replace the water heater because of the leaky plumbing, or because of the restoration or improvement of the bathroom. That was a separate issue. The plumber just happened to be on site, checked out the water heater, gave a recommendation to replace it.

Jeremy Wells: All of the work done [00:35:30] on the bathroom and the ceiling and the floor would have still happened, and would have happened exactly the same way, regardless of whether or not the taxpayer actually replaced that water heater. So in that case, we might be able to separate that out as a separate expenditure. But everything else that happened is all incidental to the restoration of that bathroom. And so therefore it's all going to be considered part of the same improvement. Now, this Treasury decision includes three safe harbors that [00:36:00] can simplify this decision for taxpayers. A safe harbor is essentially a way in tax law to work with one of these kind of complicated situations and provide a simplified and more taxpayer friendly way of dealing with it. But usually these safe harbors have some restrictions on them and some qualifications that come in. And the other thing is, [00:36:30] all three of these safe harbors are elective. It's important to remember that as well. In order to take advantage of them, the taxpayer has to elect to use them. Now the taxpayer can just decide not to make that election. In other words, the, the taxpayer has the freedom to say, I don't want to use these safe harbors. I'm fine with the normal tax treatment of these expenditures, and in a lot of cases, that's going to be having to capitalize those expenditures [00:37:00] with these safe harbors. Do is it provides a way, if the taxpayer qualifies, to be able to go ahead and expense some of these expenditures, that can help the taxpayer, that can help shift some of these expenses from having to be capitalized and therefore depreciated over time, to being able to just expense them in the year that those expenses were incurred.

Jeremy Wells: The first of these safe harbors is called the de [00:37:30] minimis safe harbor. This is in Treasury regulation 1.2 63A1F. This is probably the most common safe harbor and the most common An election that in my firm that we have on the tax returns that we prepare. Now, this is not just for rental property owners. It's really for any trade or business owner that's dealing with any kind of purchases, that [00:38:00] there might have to be a decision as to whether to expense versus capitalize that expenditure. But, uh, it's it's one of the, these, uh, safe harbors that's particularly available to, uh, rental property owners. But again, all three of these safe harbors are available to, uh, any trade or business. And trades and businesses include more broadly typically uh, include rental [00:38:30] properties as well. So this first safe harbor is the de minimis safe harbor, which allows a taxpayer to expense either invoices or items. Uh, and if the if the item is separately identifiable in terms of its cost, then you can go all the way to the level of the item, the specific item, or you can go with the entire invoice.

Jeremy Wells: If the invoice or the item falls below a certain dollar threshold, then the taxpayer [00:39:00] can expense that entire amount as long as the taxpayer's accounting procedures allow for expensing those costs below a certain amount. Now, most small business owners, they don't have formal written accounting procedures. And that's fine. We'll talk about the exception to that here in a minute. But generally for taxpayers with an applicable financial statement. And that's the term used in this regulation an applicable [00:39:30] financial statement. And I'll talk about what that is here in a minute. The threshold is $5,000 per invoice or item. So essentially if that invoice or item is less than $5,000, then it can immediately be expensed instead of capitalized and depreciated over time. Now, an applicable financial statement includes any financial statement that's required to be filed with the Securities and Exchange [00:40:00] Commission. So this is the 10-K or the annual shareholders report that gets reported to the SEC and is made publicly available on the SEC's website. And this is what a lot of investors use to make their investing decisions. This is how the SEC ensures compliance among companies. So these are typically, uh, these financial statements that are reported to the SEC and they usually reflect audited financial statements. And that's a second category [00:40:30] of applicable financial statement is a certified audited financial statement that's accompanied by a report of an independent certified public Accountant or CPA. In fact, this is what the CPA license is all about is auditing companies financial statements.

Jeremy Wells: So if it's a truly audited set of financial statements, not a lower level of assurance. But if the assurance reaches the point of audit and there is a written audit report that accompanies those financial statements, then that qualifies as an applicable [00:41:00] financial statement. And then there's a third category, which is any financial statement required to be provided to a federal or state government or agency other than the SEC or IRS. That is a non tax financial statement. So tax returns don't count. You can't take a state tax return for a business and call that a an applicable financial statement. It has to be a financial statement that is required to be filed [00:41:30] or provided to a federal or state government or agency that is not a tax return. So if the financial statement meets one of those three categories, then it's an applicable financial statement. And that business can use the de minimis safe harbor for any invoices or items less than $5,000. Now, most small businesses, that's a lot of rentals as well, don't have those. They don't have applicable financial statements. They don't get audits. [00:42:00] They don't file anything with the SEC. And really, the only thing that they are filing is tax returns. And tax returns don't count as applicable financial statements. So there is a provision in the safe harbor for taxpayers that don't have applicable financial statements. Originally, the threshold was set at $500 in the regulation, and that was when these regulations were promulgated [00:42:30] back in the early 20 tens.

Jeremy Wells: So about 2011 2012. Pretty quickly, though, IRS and Treasury Department started getting, uh, complaints and comments from business owners, from tax advisers, uh, and from others that that $500 amount was way too low even ten years ago. Uh, the cost of normal business, uh, [00:43:00] equipment, computers, tablets, cell phones, those were easily over $500. And so if you, as a business owner, bought a new cell phone to use in your business, and that cell phone was $600, you had to put that on the balance sheet and depreciate that. And really, this safe harbor didn't have the effect [00:43:30] for small businesses that it was intended to because of the way prices were even as much as ten years ago. There just wasn't enough room in under that cap, under that $500 cap to really help small business owners. So in IRS notice 20 1582, IRS increased that threshold to $2,500. Now there are still some higher end laptops and that sort of stuff that are still above $2,500. I am a Apple ecosystem [00:44:00] person. I buy Mac computers. Some of those I don't buy the ones that are over $2,500, but some of them can be over that amount. But $2,500 is a lot better in terms of thinking about the everyday kind of small business purchases like cell phones, computers, tablets, those sorts of things than $500. Now, again, this is an annual election, so there actually needs to be a statement on the return saying that the [00:44:30] taxpayer is making the election to apply the de minimis safe harbor under Treasury Regulation Section 1.2 63A1F, and that statement needs to actually be printed with the return, and it needs to be on the return each and every year that the taxpayer wants to use that safe harbor.

Jeremy Wells: Now, the taxpayer can decide in a year to make the election, and then the following year not make the election, and then the following year after that, make the election [00:45:00] again. Each year is independent of any other year. You're not locked into it. And if you choose not to elect the election, then you can always make it again the next year. But once you make that election for a tax year, it applies to all qualifying invoices or items purchased during that year. So if you're a taxpayer that doesn't have applicable financial statements and you make the election for one year, then all of the purchases that are below $2,500. [00:45:30] All of the invoices are items have to be expensed. There's no choosing what you want to expense versus capitalize once you make that election. The second safe harbor is the safe harbor for small taxpayers. This is Treasury Regulation section 1.2 63A3H. Taxpayers with eligible building property and average annual gross receipts of $10 million or less for the preceding three years [00:46:00] qualify for this safe harbor. So, as the name implies, small taxpayers.

Jeremy Wells: This is for essentially building owners, rental uh, owners with gross receipts of $10 million or less. So if you own a an entire portfolio of large properties and you're grossing over $10 million by definition of this safe harbor, you're not a small taxpayer. But if you own a rental property and your gross receipts are less than $10 million. You qualify. You [00:46:30] might qualify for this safe harbor. Now, eligible building property is a building unit of property. We talked about unit of property before, such as a rental unit with an unadjusted basis of $1 million or less. So again, inherent within this is that we're not talking about large apartment buildings or office complexes. The unadjusted basis. So what you originally purchased that property for has to be $1 million or less in order for it to be an eligible building. [00:47:00] Now, this election is actually this safe harbor that you can elect into is actually for, uh, an individual building. So you can own multiple buildings and some of them qualify, some of them don't. And as long as you as the taxpayer qualify that you have annual gross receipts of $10 million or less, you can elect to apply this to specific buildings, even if you have some buildings that don't qualify, or you can elect to use it on [00:47:30] one building and not the other building. Even if both of them qualify, the taxpayer can use the safe harbor if the total amount paid for the year for all of the repairs, maintenance, and improvements on a specific building doesn't exceed either $10,000 or 2% of the unadjusted basis of the building, which if you have a building that is $1 million, that's $20,000, and you would take the lesser of those [00:48:00] two numbers.

Jeremy Wells: So essentially it's $10,000, or if it's less than $500,000 of unadjusted basis, that building, then it's going to be 2% of that unadjusted basis. The safe harbor is an annual election, again made on a building by building basis. And again, you have to attach that statement to a timely file tax return, including extensions. And the there's no picking and choosing between these safe harbors. The taxpayer can still use [00:48:30] that de minimis safe harbor, even if she doesn't qualify for the safe harbor for small taxpayers, and vice versa. And then the third safe harbor is for routine maintenance. This is Treasury regulation section 1.2 63A3I. This safe harbor applies to activities that the taxpayer reasonably expects to have to do at least once during a ten year period to keep a building structure or a building system in ordinarily [00:49:00] efficient operating conditions. So notice that the de minimis safe harbor was just about invoices or items. And that's going to be applicable for any small business or trade or rental property. The safe harbor for small taxpayers is about a building, and the safe harbor for routine maintenance is also about a building structure or a building system.

Jeremy Wells: So these two are particular to rental property owners. It does not apply the final safe harbor [00:49:30] for routine maintenance, though it does not apply to any betterments adaptations or restorations. So this is basically just a way of saying that if it qualifies as an improvement, then it probably needs to be treated as an improvement. However, if it fits this definition of at least once every ten years or so, you're going to have to do this in order to maintain and keep operational this building structure or system. Then you're going to want to [00:50:00] apply this safe harbor. So if we think about what happened in this case, we have the plumbing repairs totaling $4,000. That's not going to meet any of the that's not going to meet the de minimis safe harbor for sure. And plumbing repairs really shouldn't happen that often. Um, and so that's not going to be routine maintenance. The the safe harbor for small taxpayers. I'll come back to in a minute. Because remember, we have to look at the total cost for the property. The bathroom renovation totaled $16,000. [00:50:30] That's definitely not de minimis. And that's definitely not routine maintenance. The new water heater and installation cost of $4,000. Now a water heater. Like I said earlier, that probably needs to be looked at fairly regularly. Definitely once within every ten years or so. Uh, water heaters seem to last, especially the residential sized ones. They seem to last, I don't know, like every 6 to 8, maybe ten years.

Jeremy Wells: Um, but definitely once within every ten years or so, [00:51:00] you need to plan on replacing a water heater that probably qualifies for that safe harbor for routine maintenance. In fact, in my firm, when we work with rental owners, we end up expending a lot of water heaters, uh, that are replaced using particular in particular, that safe harbor. And then the cost to repair the upstairs floor and downstairs ceiling totaled about $3,000 just as a review. So notice that none of the invoices write. None of these costs totaled less than $2,500. It's possible [00:51:30] that some of the bathroom fixtures new fixtures totaled less than $2,500. But again, remember, we need to look at those as incidental to the entire restoration. So we're probably going to treat all of those expenses as part of a single restoration and therefore as an improvement, given that the total expenses were way more than $10,000. Uh, we're not going to be able to look at that safe harbor for small taxpayers if the total of all the repairs, uh, were less than $10,000, [00:52:00] we could probably look at that. And then the safe harbor for routine maintenance. Again, the water heater replacing that once within every ten years seems reasonable. Uh, and so that plumber probably could have made that recommendation even without the the leak and the damage and the restoration of the bathroom. So we can we're probably pretty safe taking that safe harbor for routine maintenance for the water heater.

Jeremy Wells: So again, it's important to keep in mind [00:52:30] these three different safe harbors, the de minimis safe harbor under $2,500 for pretty much virtually any small business or rental owner, the safe harbor for small taxpayers, and the safe harbor for routine maintenance. Those are available mostly just for rental owners. But in general, when it comes to that decision of whether to repair versus improve, it's important to look at these regulations, to read through them, to ask yourself, are we doing are we bettering [00:53:00] this property? And this is true of whether it's real property or a vehicle or some other type of asset. This is not just for buildings. This is for any type of asset, whether we're doing some sort of betterment, some sort of restoration or some sort of adaptation, if it's one of those three, then it's probably an improvement. And unless you can apply one of these safe harbors to that, you're going to have to capitalize those costs. Otherwise, if [00:53:30] it's not one of those three types of improvement, or if you can apply one of these safe harbors, then you can be pretty sure about being able to expense it. But it's important to keep all of that in mind whenever these big ticket items come through. Uh, in the, in the, uh, taxpayer's books or records. So that's how to make the distinction between repairing and improving and some of these safe harbors that can help you out, help you and your the taxpayer out when it comes to making that determination. [00:54:00]