Hi, I'm Brandon Hall, a real estate CPA and CEO of Hall CPA, and today I want to talk to you about when to deduct something as repair versus capitalizing it as an improvement.
For the vast majority of use cases, a repair is going to be a small fix that doesn't cost a lot, whereas an improvement is going to be a large fix or a full blown replacement that costs a lot of money.
A repair is something that I can claim today on my P&L as an expense, which means that it reduces my net operating income and effectively gives me an immediate tax benefit.
An improvement is something where I have to add the cost to the balance sheet and depreciate the asset over its useful life, which effectively means that I recover my costs over time, meaning I also get my tax benefit over time rather than in the year that I make the improvement.
An easy way to determine if a cost can be deducted as repair is if it meets the De Minimis Safe Harbor threshold of being less than $2,500. The De Minimis Safe Harbor is meant to ease the accounting burden for taxpayers. So if your cost does come in less than $2,500, you can immediately expense it as a repair.
I should note that you cannot use the De Minimis Safe Harbor for inventory. So if you're flipping property, you cannot use the De Minimis Safe Harbor. You cannot use the De Minimis safe harbor for new rehabs when you acquire property and you cannot use the De Minimis safe harbor for land.
You do have to make an annual election on your tax returns whenever you use the De Minimis Safe Harbor, and you must also retain great bookkeeping records because the De Minimis Safe Harbor is a book conformity tool more than it is a tax strategy. All that means is that if you're going to use the De Minimis Safe Harbor, you must maintain excellent bookkeeping records to make sure that you use a great software such as Azibo to track all of your expenses and track all your receipts.
If an expense is more than $2,500, it doesn't automatically mean that you have to capitalize and depreciate that costs. Instead, we have to look deeper into the tangible property regulations, which means looking at the betterment, adaptation and restoration tests, and because it gets complicated fast, I highly recommend that you use a competent tax advisor to help you understand how the betterment, adaptation, restoration tests work.
At a really high level, if your repair to the property does not constitute a material improvement to the system that's being impacted, then you still do not have a capital improvement - you just have a repair.
To illustrate this, there's an example in the Treasury Regulations where the taxpayer replaces two HVAC units, but the total HVAC system is made up of 10 HVAC units. And because 2 out of 10 is not material, they could deduct the cost as a repair to the HVAC system rather than having to capitalize and depreciate the cost of the two HVAC units.
So, if your repair makes one of the systems and your rental property materially better, then it's going to be an improvement that needs to be capitalized over the useful life of the asset.
But if it doesn't materially improve the system, it can be deducted today as a repair. Again, the tangible property regulations are nuanced and extremely complex, so don't go about it on your own.
But in general, if you are doing a full gut rehab, everything is going to be capitalized as an improvement. If you're making little improvements here and there, you might be able to deduct them as as a repair, especially if the cost is less than $2,500 and can qualify for the De Minimis Safe Harbor election.
Brandon Hall is a real estate-focused CPA and the CEO of Hall CPA. Learn more about Brandon and his team over at https://www.therealestatecpa.com/