Repairs Versus Improvements (revisited)

By Jason Watson, CPA
Posted Saturday, September 7, 2024

This section is a mini version of our repairs versus improvements and rental property rehab sections on pages xx and yy. Here is a quick summary-

According to IRS Revenue Ruling 2000-4,

Section 263(a) and § 1.263(a)-1(a) provide that no deduction is allowed for any amount paid out for permanent improvements or betterments made to increase the value of any property or estate. Section 1.263(a)-2(a) provides that capital expenditures include the cost of acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable year.

Cool. The things you buy that have a useful life substantially greater than one year are considered a capital expenditure (capex) and must be capitalized in most situations. What the heck is capitalized? Is this a grammar thing?

Simply put- you can either expense or capitalize a purchase. Expensing the purchase is an immediate deduction and therefore reduction in taxable income. Capitalizing the purchase requires listing the asset on your fixed asset listing and expensing over time through depreciation.

Step 1 Unit of Property

The first step is determining what you are repairing or improving? The unit of property (UOP) is generally the entire building including its structural components. However, under the final tangibles regulations, the improvement versus repair analysis applies to the building structure and each of the key building systems separately. There are a total of 9 separate systems if you also count the building structure itself.

Step 2 Safe Harbors

The next step is to run through the three big safe harbors for rental property owners-

• De Minimis Safe Harbor Election

• Safe Harbor Election for Small Taxpayers (sounds a bit condescending)

• Safe Harbor for Routine Maintenance

We discussed these in fine detail in our improvements versus repairs section. De minimis is the class favorite since it is quite simple and covers most purchases or situations. However, small taxpayers and routine maintenance have some teeth, but are commonly overlooked by even the most experienced tax professionals.

Step 3 Betterment, Restoration and Adaptation

If the expenditure falls under the betterment, restoration and adaptation tests, then it is considered a capital improvement, and therefore must be capitalized and depreciated (versus immediately deducted).

The final tangible property regulations define these terms in amazing detail, but here is a small summary with the real estate investor in mind-

• Betterment. You fix a material defect in the rental property or UOP such as a cracked foundation. An addition or enlargement, such as finishing the basement, is also a betterment. A betterment is also amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property (UPO) where applicable.

• Restoration. You replace a major component such as replacing a roof. You restore a UOP that has deteriorated to a state of disrepair and is no longer functional for its intended purpose, including rebuilding after a casualty loss.

• Adaptation. According to the final tangible property regulations, “An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.” Is converting a garage into a casita or another bedroom considered an adaptation or betterment? Hmmm…

You can think of BRA or BAR when trying to remember these. No one thinks of ARB or RAB, however.

Qualified Improvement Property

Keep in mind the mini loophole that is afforded to rental properties deemed to be nonresidential based on transient tenants or guests. There are some expanded Section 179 expensing opportunities that we review as well in our qualified improvement property (QIP) section.

Rental Property Renovations (Rehab)

The first consideration with renovating your rental property is to keep excruciating details on what was purchased. A refrigerator. A cabinet. A light fixture. Parse those out best you can. Why? As you learned with cost segregation, if we can clearly identify personal property, we can accelerate depreciation without the need of a cost segregation report.

We mentioned the Hospital Corporation of America v. Commissioner, 109 Tax Court 21 (1997) court case in the Cost Segregation section. This is the landmark case that allowed the property owner to detail their renovations line by line, and assign certain items to be 5-, 7- or 15-year property (and therefore eligible for accelerated depreciation with bonus depreciation or Section 179 expensing).

As mentioned previously, this section is a truncated version of our repairs versus improvements and rental property rehab sections.