One of the benefits of owning real estate is the ability to take advantage of depreciation. The purchase or construction of a building results in the asset being capitalized to your balance sheet and, over time, depreciated. Depending on the type of building, commercial or residential, the straight-line depreciation will be computed based on a 39-year (commercial) or 27.5-year (residential) asset life. As the building is depreciated, an expense is included against rental income that lowers taxable income. Remember, this depreciation is a non-cash expense that lowers taxable income but does not require a direct payment. Additional money spent to improve the property is also capitalized and depreciated. 

As an example, if a rental property generated $25,000 in rental income and had operating expenses of $15,000 (mortgage, interest, utilities, property taxes, etc.), without depreciation, taxable income and cash in hand would be $10,000. Taxes at 37% for federal income tax would leave the taxpayer with $6,300 in cash. However, when we include an additional $5,000 of depreciation, the cash in hand before taxes is still $10,000, and the cash in hand after taxes increases to $8,150 ($25,000 less $15,000 operating expenses & $5,000 depreciation = $5,000 taxable income less $1,850 income taxes (37%) ). 

Through cost segregation, the amount of depreciation can be dramatically increased, reducing taxable income to zero. The result is a cash in hand of $10,000 for the taxpayer with no taxes due. 

Improvements or Repairs?

Real estate owners must make repairs and, in many cases, improve their properties. Whether the money spent is a repair or should be classified as an improvement is critical as it impacts budgeting, cash flow, and taxes. A repair can be expensed immediately, which reduces taxable income by the total amount of the repair. An improvement must be capitalized and depreciated over its useful life (unless it can be expensed through bonus depreciation). This means a real estate owner will pay for the cost of the improvement and can not reduce taxable income by the amount spent. So, how these purchases are classified can make a significant impact on taxable income and cash flow for the year. To better understand how to classify an expenditure for an improvement or repair, we need to better understand the definitions of both. 

Safe Harbor

Let’s start with the safe harbor rules to eliminate a few variables. Several safe harbors are available to determine whether an expense is a deductible repair or an improvement that must be capitalized. 

• De minimus safe harbor election: A taxpayer may elect to treat expenses that have a useful life of less than 12 months and are less than $5,000 for a unit of property (Reg Section 1.263A-1(f)) as a repair.
• Remodel/Refresh safe harbor election: Specifically for retail and restaurants for expenses related to refreshing, remodeling, repairs, maintenance, or similar activity (REv Proc 2020-25)
• Safe harbor for small taxpayers to deduct building improvements: the lesser of 2% of the unadjusted basis of the building or $10,000 for a taxpayer whose average gross receipts over the prior three years are less than $10M.
• Routine maintenance safe harbor: Routine maintenance is the amount paid to keep the building structure or system in normal operating condition and can be expensed fully.

Improvements

Money spent to improve a property must be capitalized and depreciated over the useful lives of the improvements. Some improvements are structural and would be depreciated over the life of the building (27.5 years for residential buildings and 39 years for commercial buildings). However, some improvements, such as cabinets, countertops, interior windows, carpets, and many others, can be depreciated more quickly due to asset and class life characteristics defined in the Internal Revenue Code. 

An improvement, as defined in the IRS Repair Regulations, is the amount paid for the 

• a betterment to the unit of property;
• restoration of the unit of property; or
• adapting the unit of property to a new or different use.

This brings up a few questions that we can unpack;

What is a Unit of Property?

What is considered a Betterment?

What defines a Restoration?

When do we consider something an adaptation versus a repair?

Let’s break these down individually.

Unit of Property

Generally, the unit of property for a building is the entire building including its structural components. However, under the tangible property improvement rules, the unit of property analysis applies to the building structure and each of the key building systems. Specifically, the building systems are defined as;

• Plumbing System;
• Electrical System;
• HVAC System;
• Elevator System;
• Escalator System;
• Fire protection and alarm system;
• Gas distribution system;
• Security systems.

Betterment

Amounts paid for the betterment of a unit of property are those that correct or fix a material condition or material defect that existed prior to acquisition or arose during the production of the unit of property. 

While the regulations do not define “material,” several examples are provided to help understand conceptually the term. 

Example

Angie acquires land with a leaking underground storage tank left by the previous owner. Costs to clean up the land are an improvement because the correct a material condition or defect that arose prior to the acquisition. 

Restoration

An amount restores a unit of property if it:

• is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss, other than a casualty loss;
• is for the replacement of a component of a unit of property for which the taxpayer has taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
• is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss,
• returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;

NOTE: The definition of restoration differs from routine maintenance in the key fact that restoration requires that the unit of property has deteriorated to a state of disrepair and is no longer functional. 

Adaptation to a new or different use

An amount paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of the unit of property when the taxpayer put it into service.

Disposals

Amounts spent to improve a property typically result in building components being disposed of as part of the improvement process. As an example, improving a kitchen typically requires the removal of flooring, countertops, cabinets, appliances, electrical, plumbing, etc. The cost of these assets can be valued and taken into account as an expense on the tax return. 

However, to value the assets being disposed of, a cost segregation study should be performed to properly allocate the cost of each item before it is disposed of. Pictures of the assets prior to demolition and pictures of the completed improvements are helpful for documentation of the assets disposed of and added to the property. 

Tax Planning Opportunity

From a tax planning perspective, the expense related to the disposal of these assets will increase the overall depreciation taken in the year the improvements (and dispositions) are placed in service.

An experienced engineer with knowledge and understanding of building systems and construction should complete a cost segregation study. The study should also take into account assets that have been removed and disposed of to capture the maximum amount of depreciation and expense.

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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting. Photo courtesy of Daniel Ramirez on Flickr.