ARTICLES

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​The Small Asset Property Owners Guide

​By Pierre Mouchette | Real Property Experts LLC

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Once you have placed your rental property into service, you will need to determine whether repairs and maintenance expenses that you incur should be classified as a regular expense or a capital improvement.   Why, it all boils down to capitalization and depreciation. 
Most rental property owners prefer these costs classified as regular repair and maintenance expenses in order to maximize their current year deductions and minimize depreciation recapture. 

Explanation of Terminology
Repairs and maintenance - are generally onetime expenses that are incurred to keep property habitable and in proper working condition.  Examples of common repair and maintenance expenses include but are not limited to:

• Painting.
• Fixing existing: faucet or toilet, a broken pipe, a few planks or tiles on a floor, a cabinet door, an AC unit, a few shingles on a roof.
• Inspect or clean part of the building structure and/or the building systems.
• Replace broken or worn-out parts with comparable parts.

Capital improvements - an addition or change that increases the property’s value, increases its useful life, or adapts it (or a component of the property) to new uses.  These items fall under categories sometimes called betterments, restorations, and adaptations.  Examples of that constitute capital improvements are:

• Additions - (e.g., additional room, deck, pool, etc.).
• Renovating an entire room (e.g., kitchen).
• Installing central air conditioning, new plumbing system, etc.
• Replacing 30% or more of a building component (i.e., roof, windows, floors, electrical system, HVAC, etc.).

Depreciation - one of the most important deductions for rental real estate investors because it reduces taxable income but not cash flow.  For many Small Asset Property Owners, of concern is determining a property’s depreciable basis. 

• The goal is to allocate as much of the property’s purchase price to the building value as possible to maximize depreciation expense since land is never depreciated.  The portion allocated to the building is depreciated over 27.5 years, per the IRS guidelines for residential income property.  While allocating 20% to land and 80% to the building is a common practice, under an audit you may have to substantiate why you chose those numbers.  This is commonly done by finding the land versus building value on an appraisal or property tax card filed with the county.  You can also use comparable land sales to make this determination or commission a cost segregation study or appraisal by a third-party professional.  Should you decide to deviate from the tax assessor’s land versus building value ratio, you will need to be prepared to support your determination in an audit with independent documentation prepared by a third-party professional.

Cost segregation studies and 100% bonus depreciation - using a cost segregation study, certain costs previously classified as 27.5-year property, are instead classified as personal property or land improvements, with a shorter 5, 7, or 15-year rate of depreciation using accelerated methods to increase near-term deductions.  A tax accountant and their specialized software will do the math.

• Generally, between 20-30% of the property’s purchase price can be reclassified under these shorter class lives which can significantly increase a property’s depreciation expense.  Thanks to The Tax Cuts and Jobs Act, 5, 7, and 15-year property is now eligible for 100% bonus depreciation, which means its entire cost can be written off in the first year of ownership.

It is important to note that cost segregation studies make the most sense for landlords who are considered real estate professionals for tax purposes or expect to come in under the passive loss limits discussed below.  Cost segregation studies may also be worth considering if you consistently have net income from passive activities or a capital gain from the sale of a rental, since losses generated by rental properties can generally offset other passive income or gain from the sale of rental property.
Safe Harbors - will prove useful in moving some expenses that would otherwise be classified as capital improvement into regular expenses, such as:

• Safe Harbor for Small Taxpayers
• Routine Maintenance Safe Harbor
• De Minimis Safe Harbor

 
Recommended reading: IRS - Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.  In reading this RULE you will learn how the IRS approaches capital improvements versus repairs & maintenance expenses.
 

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RPE Category (Digital Digest)

REAL ESTATE | RESIDENTIAL SMALL ASSET INVESTOR | Investment | Opportunities

PUBLISHED:

March 16, 2021

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