Improvement Versus Repairs

By Jason Watson, CPA
Posted Monday, August 5 2024

We might have thrown out some terms without slowing down to define them. 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?

There is capitalization in finance, and perhaps even in the deal structure on your rental property (debt versus cash versus investors). In accounting, and in tax return preparation, capitalization is-

an accounting method in which a cost is included in an asset’s value and expensed over the asset’s useful life, rather than expensed in the period the cost was incurred. Capitalization recognizes a cash outlay as an asset on the balance sheet rather than an expense on the income statement.

Moreover, a capital improvement is an expenditure that increases a property’s value, useful life or adapts to new use. This is also referred to as betterments, restorations and adaptations. Fun!

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.

Accelerated depreciation through bonus depreciation or Section 179, or both, can allow for an immediate deduction of an otherwise capital asset. We’ll talk about accelerated depreciation and Section 179 expensing in a bit on page xx.

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. The building systems are the

• plumbing system

• electrical system

• HVAC system

• elevator system

• escalator system

• fire protection and alarm system

• gas distribution system, and

• the security system.

So, 9 total 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 an earlier section on page xx. 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 quick 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.

With reference to betterment and the word “material,” the IRS offers this-

The term “material” is not defined in the final tangibles regulations. Although the final tangibles regulations include examples that refer to percentage increases, these examples are provided to assist you in understanding the rules. These percentages are not intended to set a standard, for example, a particular percentage increase in square footage or capacity, for determining whether the amount paid is a “material” betterment. In determining whether a betterment is “material”, you should use common sense and reasonable judgment as applied to your own facts and circumstances.

Earlier we asked you to remember Example 25 when discussing Safe Harbor for Routine Maintenance where a property owner replaced 100 out of 300 windows, and the expenditure was deemed to be routine maintenance (repair) and not an improvement.

On one hand, the 100 of 300 is a very specific percentage. On the other hand, the IRS suggests that a hard number, or bright line as we like to say, does not exist. Regardless, the 33% should be a decent barometer as you navigate the improvement versus repair maze.

Wait! There’s more! Using the window example from page xx, if you replaced all 300 windows at once it would likely be a capital improvement. However, if you replace 100 each year for three years, you might be able to call it all routine maintenance under the safe harbor. Spreading things out also helps with cash flow. Possibly a win win, but don’t break out the bubbly quite yet. There would be some things to discuss and some risk to explore.

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.