Over the years, one of the more vexing tax questions for property owners has been how to tell whether a cost is a repair or an improvement. The importance of this cannot be overstated. If a cost is treated as a repair, it is deductible in the current year; if it is treated as an improvement, it must be depreciated over the life of the asset.
In 2014, the IRS attempted to settle the question by implementing new and lengthy regulations. The new maxim is that repair and maintenance costs must be capitalized unless an exception applies. Exceptions include “qualifying materials & supplies” and certain “repairs & maintenance” costs. As you may guess, the rules defining “qualifying materials & supplies” and “certain repairs & maintenance” are complex, and places a burden on tax preparers and taxpayers alike to understand their nuances (of which there are many). For example, the new rule states that if a cost is a “Betterment, Adaptation or Restoration,” it is an improvement and must be capitalized.
Small taxpayers can avoid some of the angst. Instead of having to untangle the code to determine how it applies to their particular set of facts, small taxpayers now can make an election to deduct the costs of improvements to eligible building property.
Definition of a Small Taxpayer
To qualify for the small taxpayer safe harbor, your building must:
- Have average annual gross receipts of $10 million or less for the three preceding tax years; and
- The eligible building property must have an unadjusted basis of $1 million or less, or if you leased the property, the rent you will pay over the entire term of the lease including renewal periods must be under $1 million.
Deductible Repairs and Improvements
The total amount paid during the year for repairs, maintenance and improvements to eligible building property cannot be more than the lesser of:
- 2% of the unadjusted basis of the eligible building property (typically its original cost); or
Warning: If the total amount you spent on a building for repairs and improvements exceeds the limit, none of your expenditures will qualify for the safe harbor.
Additional warning: Included in the total amount spent are costs which would otherwise be deductible under the De Minimis Safe Harbor and Routine Maintenance Safe Harbor exceptions (see Other Safe Harbors below).
Small Taxpayer Safe Harbor Election
The safe harbor election is irrevocable. If you meet the Small Taxpayer qualifications, you must make your election by attaching a statement to your original return that is filed in a timely fashion, including extensions. If you report your building properties on your individual return, a single election will cover all properties.
Applying the Small Taxpayer Safe Harbor
Entities are made at the entity level. Therefore partnerships, LLCs and S-corporations each make their own elections.
If the small taxpayer safe harbor applies and you make the election, you can deduct your costs as business expenses or expenses for the production of income in the tax year you paid them, as long as they otherwise qualify for a deduction.
Bear in mind, however, that the passive activity loss rules could prevent you from enjoying the immediate benefit of the deduction. It is typically better to carry forward the losses though, than to capitalize costs and therefore run the risk of having to pay recapture tax on gain when you sell the property.
However, if your total amounts paid on a particular property exceed the limit, none of the amounts will qualify for the safe harbor.
Other Safe Harbors
Other taxpayers who do not qualify as “small taxpayers” or do not make the election, can:
- Make a de minimis safe harbor election and deduct costs of small dollar expenditures up to $2,500 per invoice line item ($5,000 if your financial statements are audited by a CPA firm). For example, this election would allow you to deduct the entire cost of ten appliances costing $2,000 each.
- Deduct the cost of routine maintenance performed to keep a unit of property in efficient operating condition. To qualify under the Routine Maintenance Safe Harbor, you must reasonably expect that maintenance will recur more than once over 10 years, or during the ADS class life of the property.
As with so many tax provisions, some planning is required to get the most out of the small taxpayer safe harbor. It pays to think ahead when it comes to getting the current deductions you need to offset income.