Repair or improvement? The routine maintenance safe harbor and the betterment, restoration and adaptation test
Under the IRS tangible property regulations, work on a rental building is an improvement you must capitalize if it is a betterment, a restoration or an adaptation to a new use. Otherwise it is generally a deductible repair. Routine maintenance you reasonably expect to do more than once in 10 years is deemed not to be an improvement. A small taxpayer safe harbor can also let you deduct work on a building up to a dollar cap.
The question the regulations ask
The rules are in Treasury Regulation 26 CFR 1.263(a)-3-3). They apply to the unit of property, which for a rental building is the building structure and each major system such as plumbing, electrical, HVAC and the roof. You must capitalize amounts paid to improve a unit of property. An amount improves it if it is a betterment, a restoration or an adaptation to a new or different use, often called the BAR test. If it is none of these it can be deducted as a repair. The small dollar de minimis safe harbor is a separate rule that works by invoice size, and this post is about the nature of the work.
Betterment: three kinds
An amount is a betterment only if it falls into one of three categories under paragraph (j).
- It ameliorates a material condition or defect that existed before you acquired the property, or arose during production, whether or not you knew about it.
- It is for a material addition, including a physical enlargement, expansion or extension, or a material increase in capacity.
- It is reasonably expected to materially increase the productivity, efficiency, strength, quality or output of the unit of property.
Example a made-up owner pays $4,200 to add a second bathroom to a unit. It is a material addition, so it is a betterment and must be capitalized and depreciated.
Restoration: six situations
Under paragraph (k), you must capitalize an amount paid to restore a unit of property if it does any of the following.
- Replaces a component for which you properly deducted a loss, other than a casualty loss.
- Replaces a component whose adjusted basis you took into account in figuring gain or loss on a sale or exchange (for example, a partial disposition election).
- Restores damage from a casualty where a basis adjustment is required.
- Returns deteriorated, nonfunctional property to its ordinarily efficient operating condition.
- Rebuilds the property to a like-new condition after the end of its class life.
- Replaces a part or combination of parts that makes up a major component or a substantial structural part.
The last one catches most owner questions. A major component performs a discrete and critical function; a substantial structural part is a large portion of the unit's physical structure. Replacing a whole roof or a whole heating system is the classic case. Replacing a few shingles or a thermostat is not. If you replace a major piece, the partial disposition election can let you write off the old piece's remaining basis.
Adaptation: a new or different use
Under paragraph (l), an amount paid to adapt a unit of property to a new or different use must be capitalized if the use is inconsistent with the way you ordinarily used the property when it was first placed in service. Converting part of a residential building into a commercial space would be an example. Updating a kitchen in an apartment that stays an apartment is not an adaptation.
The routine maintenance safe harbor
Paragraph (i) deems routine maintenance on a building not to be an improvement. The work counts as routine only if you reasonably expect to perform it more than once during the 10 years after the building structure or system is placed in service. It does not apply to work that is a betterment. Repainting units and servicing HVAC on a schedule are typical.
Example a made-up owner repaints a 10 unit building every 4 years for $1,200 a unit, $12,000 in all. Because she expects to repaint more than once in 10 years, the paint job is routine maintenance and deducted as a repair. If the same $12,000 went to replacing worn-out siding with a better material on the whole building, that would be restoration or betterment and capitalized.
The small taxpayer safe harbor for buildings
Paragraph (h) lets a small taxpayer elect to deduct repair, maintenance and improvement costs on an eligible building if the total for the year is not more than the lesser of 2% of the building's unadjusted basis or $10,000. The building must have an unadjusted basis of $1,000,000 or less, and the taxpayer must pass a $10,000,000 gross receipts test. It is an election, so ask your tax preparer how to make it, and the cap applies to the building's qualifying costs for the year, so one large item can use it up.
Example a made-up building has an unadjusted basis of $900,000. Two percent is $18,000, and $10,000 is lower, so the cap is $10,000. A $14,000 roof replacement is over the cap, so the election would not apply to that year's costs for the building, and the roof is capitalized. Had total work that year been $9,000, all of it could be deducted under the election.
Keep the records that decide it
- Keep the invoice and a one-line note of what was done and why.
- Give improvements their own account in your books, separate from repairs.
- Take before and after photos for anything large.
How DoorKeeping handles it
DoorKeeping reads vendor bills with AI and codes each one to a Schedule E expense account; you confirm the lines it is unsure about with one tap. Work orders and vendor job links keep a dated record of what was done at which unit. The repair versus improvement call is yours and your tax preparer's: DoorKeeping gives no tax advice, so mark large jobs and ask before year end.
Sources
Questions
- What is the BAR test for repairs?
- BAR stands for betterment, restoration and adaptation. Work that is any of the three is an improvement that must be capitalized under 26 CFR 1.263(a)-3; work that is none of them is generally a deductible repair.
- What is the routine maintenance safe harbor?
- Routine maintenance on a building is deemed not an improvement if you reasonably expect to do it more than once during the 10 years after the building or system is placed in service, and it is not a betterment.
- Is replacing a roof a repair?
- Usually not. Replacing a whole roof generally replaces a major component or substantial structural part, which is a restoration. Patching leaks is generally a repair. Ask your tax preparer.