With rental properties, you always prefer to have fix-ups classified as repairs and not as improvements. The reason is that repairs are deductible now, while improvements on rental property are capital items that must be depreciated over a recovery period of 27.5 years for residential rental property. With your residence homes, you have a different attitude. Any repair made to a residence is completely nondeductible. You don’t get to add it to your basis and you don’t get a deduction. Improvements, on the other hand, get added to the basis of the home and help reduce the gain, if any, when you sell the home. So, with a residence, you want improvements and not repairs.
Tips to ensure repairs for your rental properties:
- Segregate repairs from improvements.
- Fix a minor portion only.
- Use similiar, comparable, or less expensive materials.
- Fix damanged areas only. When you expand your repair to areas of the property that are not worn out, broken, or deteriorated, you make an improvement. For example, fixing the leaking portion of the roof versus replacing the entire roof.
- Repair after an event (something happened), such as a broken water pipe, wear and tear.
- Repair during occpancy or between tenants.
- Classifc the fix-up as a repair (or improvement) on your books.
- Try to replace less than half of any wall, ceiling, or floor.
Fortunately, landlords may use three “safe harbor” rules to bypass the repair-improvement conundrum and deduct many expenses regardless of whether they should be classified as improvements or repairs under the IRS regulations. These are:
- Safe harbor for small taxpayers
- Routine maintenance safe harbor
- De minimis safe harbor
Safe harbor for small taxpayers (SHST): it allows landlords to deduct repairs, maintenance, improvements, and similar expenses IF your building costs $1 million or less. The amount of the deduction is the LESSER of: a) $10,000 or b) Two percent of the unadjusted basis of the building.
In addition, to qualify for this, a taxpayer must have average annual gross receipts of $10 million or less for the three preceding taxable years. Even better, this $1,000,000 qualification limit applies on a building-by-building basis. The small taxpayer safe harbor must be claimed anew each year by filing an election with your timely filed tax return
Example: Sam buys a home used as a rental investment property for $700,000. If he incurs $6,000 in fix-up expenses, he can deduct the full $6,000 amount, even if it would normally have been considered an improvement under the criteria noted above, since the fix-up costs were less than the $10,000 threshold. Likewise, if he owned a dozen buildings that cost about the same price, he can take advantage of the SHST for each building.
De minimus Safe Harbor (DMSH): you can deduct all fix-up expenses on a building if they are less than $2,500 (as shown on the invoice).
In general, fix-ups less than $2,500 can be deducted using DMSH. If the total expenses of a building is less than $10,000 (or 2% of the unadjusted basis of the building), all the expenses can be deducted right away. Otherwise, we must classify expenses between repairs and improvements, and depreciate improvements over time.