Deducting Repairs: New IRS Rule Eases Burden for Landlords

Here’s a bit of good news for small landlords: The Internal Revenue Service has introduced a “safe harbor” for deducting repairs to investment properties from ordinary income. Normally, the IRS does not allow you to take a full current-year deduction for anything they consider a renovation or improvement.

They only allow you to take a first-year deduction on repairs, which the IRS defines as projects that do not materially add to the value of a property, nor change its function, but only restore the property to a serviceable and rentable condition. Renovations and improvement costs have to be recovered over the useful life of the property – typically 27.5 years for residential real estate, and longer for commercial real estate.

This limitation on deductions puts a crimp on investor cash flows: Investors would almost rather maximize their current cash flow by maximizing current year deductions (except in a few special situations).

I Have to Account for What!?

In practice, this system led to some onerous record-keeping requirements on the part of landlords.

The new IRS rule, however, essentially presumes that all small landowners naturally have some repairs – and gives them a safe harbor for estimating their repairs without necessarily having to keep a crazy amount of records on hand for very small transactions. The IRS figured out it’s not reasonable for smaller investors/landlords to have a full-time, dedicated accounting staff responsible for depreciating every last widget. If you want the Full Monty version, you’ll find it at Internal Revenue Bulletin 2013-43.

Safe Harbor

The rule: If your tax basis in the property is $1 million or less, and your average annual gross receipts over the past 10 years are $10 million or less, you get a break. You can deduct up to 2 percent of the current market value of the property, or up to $10,000, whichever is less, in any given year, right off of income. You don’t have to depreciate this amount over decades, and you don’t have to hold on to detailed records every time you replace a leaky gasket in your shower or replace some wet-rotted drywall after a heavy rain. Just attach a statement to your income tax return, and make sure you file your return on time.

You can do this with multiple properties, as long as each property has a tax basis of less than $1 million.

Note: If your expenses are greater than $10,000 per property, you don’t get to safe-harbor any of it. Everything has to be capitalized over time.

Take the De Minimis Election

Under the new rule, you can elect to take a special de minimus safe harbor deduction of up to $500 per item of tangible property acquired (or produced), as long as you file your tax return on time (including allowable extensions). To do so, you need to have a written accounting procedure on file stating your intent to take the deduction.

Do you want to take more? You can deduct up to $5,000 per invoice (not per item) if you have an applicable financial statement, defined as:

  • A 10-K filed with the Securities Exchange Commission,
  • A certified and audited financial statement prepared by an independent certified public accountant, or
  • A financial statement required for a federal or state governmental entity.

The statement must be in place at the beginning of the tax year. For the property to qualify for de minimus treatment, it must have an expected useful life of less than one year.

You must be consistent. That is, you must always treat every piece of tangible property acquired or created, below this dollar amount.

Furthermore, don’t try to skate by breaking up items among multiple invoices. The IRS already thought of that, and they’re way ahead of you.

Supplies and Materials

Generally, you can deduct the cost of materials and supplies in the year purchased. You don’t have to keep track of the inventory of a bag of nails and depreciate them over the length of time they’ll be in the wall. Just keep the cost down to $200 or less per item. You can also deduct the cost of acquiring or producing property with an economic useful life of 12 months or less.

Can I Take Advantage of This for 2013?

Unfortunately, no. The IRS stated in their revenue ruling that their intent was to reduce the compliance burden on property owners, and that making the tax benefit retroactive to prior years would be “inconsistent with such a purpose.” That is, they figure the compliance burden for 2013 to be pretty much a sunk cost already. The safe harbor rules only apply for tax years beginning January 1, 2014 and onward.

Clear as mud? Better get with your tax professional, since the rules are far more complicated than I can get at in an 800-word column. For further reading, see this excellent write-up from the CCH Group and Wolters Kluwer.

Comments

Elizabeth Ann Taylor - August 5, 2014 at 12:51 pm

I heard about this last year from my CPA since we have a few small properties. After reading this I am glad I have a CPA!