Skip to content

Posted about 9 years ago

Understanding the Safe Harbor Rules and Keeping Money in Your Pocket

In the post below, I take a deep dive into the new IRS final regulations. It's a long read and sometimes complicated, so take breaks, bookmark the page, and refer back to it as necessary. 

In 2013, the IRS released a 222 page set of final regulations that replaced the enacted temporary regulations. The final regulations went into effect on January 1, 2014 and they aim to resolve age-old disputes between landlords and the IRS as to what can be classified as a repair or an improvement. 

As I am sure many of you know, repairs to your rental property that are ordinary, necessary, and reasonable in amount are classified as operating expenses that are fully deductible in the year in which they are incurred. On the other hand, expenses classified as capital improvements cannot be deducted in a single year and are instead depreciated over a long period, sometimes 27.5 years. 

For tax purposes, it is more beneficial to classify expenses as repairs. Doing so will allow you to deduct currently the full cost of the repair which in turn decreases your tax liability and keeps more money in your pocket. Due to inflation, money today is worth more than money tomorrow, hence the idea that repairs are more valuable for a landlord than improvements that are depreciated over a long period of time. 

The new final regulations come with pros and cons. On the positive side, they added three new safe harbors that landlords can take advantage of, particular those with small holdings. On the negative side, if a landlord cannot utilize a safe harbor, it will be difficult to classify fix-ups and expenses as repairs. This makes it imperative to understand the safe harbors and how they can help you come tax time.

The Three New Safe Harbor Rules

The final IRS regulations provide three new safe harbors that landlords can attempt to take advantage of. If an expense falls within any of the safe harbors, you may currently deduct it as an operating expense (a good thing). The new safe harbors are as follows:

  1. 1. Safe Harbor for Small Taxpayers (SHST)
  2. 2. Routine Maintenance Safe Harbor 
  3. 3. De Minimis Safe Harbor

If the expense does not fall within one of the three safe harbors above, you will need to determine whether the expense is classified as a deductible repair or an improvement under the regular repair rules in the IRS final regulations. 

I will address each of the safe harbors below and while they are important, you by no means need to become an expert at determining what a repair is vs. maintenance vs. an improvement. Understanding these rules allows you to speak intelligently with your accountant and ultimately better know your business. 

A Special Note on Maintenance vs. Repairs - There is no real tax difference between maintenance and repairs as they are both currently deductible operating expenses. However, maintenance is not the same thing as repairs. Maintenance is used to prevent something from breaking down. A repair is performed subsequent to a breakdown occurring. The IRS requires on Schedule E that you separately list what you spent for each category, and therefore, you must (and should) keep track of these expenditures separately.

1. Safe Harbor for Small Taxpayers (SHST)

The SHST is the primary safe harbor for smaller landlords. If you qualify, you may deduct on Schedule E your annual expenses for repairs, maintenance, improvements, and other costs of your rental building. This safe harbor is a small taxpayers best friend because it does allow you to deduct improvements you would otherwise have to depreciate. If you can qualify for this safe harbor, you won’t need to worry about any of the other safe harbors or the regular repair vs. improvement regulations. 

There are three considerable restrictions limiting the landlords who may use this safe harbor. It is imperative that landlords separately keep track of annual expenses for repairs, maintenance, and improvements. Note that the safe harbor is applied to each property separately rather than in the aggregate. 

Restriction 1 - $1 Million Building Value Ceiling - You may only utilize the SHST for buildings with an unadjusted basis of $1 million or less. Your unadjusted basis excludes depreciation and includes capital improvements. 

Restriction 2 - Annual Expenses Cannot Exceed the Lesser of $10,000 or 2% of the Building's unadjusted basis - When computing the annual expense amount, include every expense the building incurred during the year for repairs, maintenance, and improvements. Again, the beauty here is that you can make a capital improvement and expense it immediately rather than depreciate it as long as the annual expense falls within the limits described above.  

  1. Example - You own a $300,000 rental house placing your expense limit at $6,000. Your annual repairs and maintenance expenses are $2,000 and you installed new appliances totaling $3,500. Your total annual expenses for this rental property come in at $5,500 meaning you can utilize the SHST and currently deduct the entire amount. With old regulations, you would normally have had to expense the appliances and depreciate over a long period of time.

If your expenses exceed the annual limit, you are disqualified from using the SHST but you can still utilize the other two safe harbors as discussed below.

Restriction 3 - Your Annual Gross Receipts are Limited to $10 Million - This includes sales, wages, investments, etc. 

In order to claim the SHST, you must file an election with your timely filed tax return. There is not an IRS form to claim the SHST, but there are templates readily available which primarily include your name, address, taxpayer ID, and a description of the property you are claiming the SHST for. You may claim the SHST in some years, and forgo it in others as claiming it one year does not mean you must claim it in each subsequent year. 

2. Routine Maintenance Safe Harbor

Expenses qualifying as routine maintenance under this safe harbor will be fully deductible in the current year. Any landlord can use it regardless of the expense amount, type of rental property, or landlord annual income. 

Routine maintenance is defined as preventative or cyclical maintenance that is an essential part of the on-going care and upkeep of a building or building system. The IRS final regulations state that a building includes the building as a whole and nine separate systems essential to the function of the building (See discussion of UOPs below). 

The routine maintenance safe harbor includes two key areas:

  1. 1. Inspecting, cleaning, and testing of the building structure and/or
    each building system.
  2. 2. As a result of #1, replacement of damaged or worn parts with comparable and
    commercially available replacement parts.

Generally, #1 above is currently deductible as an operating expense. However, #2 is where the real value that this safe harbor provides is seen. If during an inspection or test a problem with any building or building system is discovered, the part can be repaired or replaced with a comparable and commercially available replacement part. The incurred expense, regardless of the cost, qualifies for the routine maintenance safe harbor and is fully deductible in the year incurred. As with the SHST, there are considerable restrictions limiting the ability to utilize this safe harbor.

Restriction 1 - The Ten Year Rule - Maintenance qualifies under the routine maintenance safe harbor only if a landlord reasonably expects to perform the maintenance more than once in a ten year period when the building or building's system is placed into service. To determine whether you expect to perform the maintenance more than once every ten years, you must take into consideration factors that include but are not limited to: the recurring nature of the activity, industry standards, manufacturer recommendations, and your personal experience with similar property. This rule eliminates deducting maintenance of major components such as roofs, windows, siding, and flooring under this safe harbor. However repairs of these components may be deductible under the regular IRS repair regulations. 

Restriction 2 - No Betterments Rule - The IRS states that the routine maintenance safe harbor is there to help landlords keep their properties in efficient operating condition and therefore cannot be used to deduct expenses incurred from major renovations, restorations, or improvements. 

A pitfall to the routine maintenance safe harbor is that any expense deducted under this safe harbor is applied to the annual expense limit of the SHST. Remember, no amount is deductible under the SHST if the annual expense limit is exceeded, so for example, if your annual expense limit is $6,000 under SHST but your expenses related to routine maintenance are $7,000, you are disqualified from using SHST, but can still deduct the $7,000 under the routine maintenance safe harbor. On the other hand, if your routine maintenance is $5,000, you can still utilize $1,000 of expenses under the SHST if your annual limit is still that $6,000.

Claiming the routine maintenance safe harbor is much different than claiming the SHST. It is not elective, meaning you do not need to file anything with your tax return to realize the benefits. The safe harbor is actually a method of accounting, meaning you deduct the qualifying expenses on your books as they are incurred and it will flow through to your tax return. Once you adopt this method of accounting, you must use it in each subsequent year.

3. De Minimis Safe Harbor

The De Minimis safe harbor is the last safe harbor outlined by the final IRS regulations. Landlords can use this safe harbor to deduct low-cost personal property items used in their business. It does not matter if the item would be considered a repair or an improvement as long as the item costs less than $500. 

Unless you have applicable financial statements (think SEC public companies) then the most you will be able to deduct under this safe harbor is $500 per item or invoice. Tangible personal property used in a rental business is commonly deducted under the De Minimis Safe Harbor (i.e. fully deduct a $500 refrigerator rather than depreciate it). Components required to maintain or repair tangible property are also commonly deducted under De Minimis (i.e. repairing windows by replacing window frames is deductible). 

Any piece of property with a useful life of 12 months or less must be deducted under De Minimis if the cost of the property falls within the $500 limit. 

This safe harbor is similar to that of SHST in terms of claiming it. You must file an election with your tax return and also adopt an accounting policy utilize the treatment. When you make the election, it applies to every piece or personal property you purchase during the year. 

What if You Can't Use Any of the Safe Harbors?

If you cannot utilize any of the three safe harbors discussed above due to missing the requirements, you must determine if the expense in question is a repair or an improvement under the IRS repair regulations. In order to do this, you will need to determine the property that is involved - this is what the IRS calls the "Unit of Property" (UOP). The larger the UOP, the more likely small repairs will be classified as repairs rather than improvements. 

Until now, real estate owners could claim their entire building as one UOP. This allowed them to classify major overhauls such as roof installations, replacing heating and air systems, and interior structural changes as repairs rather than improvements as these projects could be considered relatively minor to the entire UOP. However, the IRS final regulations address this and now identify nine building systems which makes it much harder to classify a repair as such. 

UOP #1 - The Building Structure - The final regulations identify the building structure itself as a UOP. This includes a building's walls, floors, ceilings, partitions, as well as any permanent covering for them (think windows, roofs, siding, etc.). Today, if a landlord improves a structural component, the expense is treated as an improvement to that single UOP, while a repair (like replacing a few singles on a roof) may be currently deducted. If you own an apartment complex with separate apartment buildings, each building is it's own UOP. 

The issue occurs when an expense previously classified as a major "repair" will likely now be classified as a structural improvement to the UOP, and as such, will need to be depreciated.

UOP #2 - Heating, Ventilation, and Air Conditioning (HVAC) This includes the HVAC's parts such as motors, pipes, radiators, etc. Replacing a motor may now be considered an improvement to the HVAC UOP and if so, will need to be depreciated. 

I am not going to go into each UOP for the sake of space, however I have listed the remaining ones below.

UOP #3 - Plumbing Systems

UOP #4 - Electrical Systems

UOP #5 - Escalators

UOP #6 - Elevators

UOP #7 - Fire Protection/Alarm System

UOP #8 - Security System

UOP #9 - Gas Distribution System

It is important to note that, while not specifically listed, appliances are their own UOPs. For instance, take a refrigerator and an oven. Neither are dependent on each other, so they are each their own UOP. However, the refrigerator and it's motor are functionally interdependent on each other and thus are part of the same UOP that is the refrigerator. 

Betterments, or improvements, that are material to a UOP must be capitalized and depreciated. Material changes are those that significantly affect the UOP. To rehash the HVAC example above, replacing the motor in a HVAC could be material to the HVAC UOP, and even though it is insignificant to the building as a whole, it is significant to the HVAC and must be depreciated. 

A Simple Checklist to Determine if an Expense is a Repair or an Improvement

If you find you are having trouble figuring out how to classify an expense, answer the three questions listed below. If the answer to all three is "no," then the expense can be classified as a repair, but if any of the answers is "yes," then the expense must be classified as an improvement. 

  1. 1. Does the value of the UOP increase as a result of the expense incurred?
  2. 2. Does the UOP's use adapt or change as a result of the expense incurred?
  3. 3. Is the UOP's useful life substantially altered as a result of the expense incurred?

Combining Repairs with Improvements Can Cause You Problems

Many times, repairs occur at the same time as improvements, especially when working on one specific UOP. The IRS repair regulations state that a landlord must depreciate all direct costs of the improvement, as well as any indirect cost incurred due to the improvement. Repairs and maintenance are indirect costs relative to improvements and may need to be depreciated if they are incurred due to the improvement. 

  1. Example - You replace a toilet in a rental property, and subsequently you re-paint and re-tile the bathroom. The re-painting and re-tiling costs incurred may need to be classified as a capital improvement rather than a repair because they resulted from the replacement of a toilet. This is why it is always important to plan expenses carefully and then document your logic for classifying those expenses.

The IRS Repair Regulations are Retroactive

The new IRS repair regulations are retroactive in scope, meaning they need to be applied to every property you acquired and still own prior to Jan. 1, 2014. You must treat your taxes and accounting as if you have been following the rules all along. You will need to sit down with an accountant and analyze your previous expenses to determine whether they are classified appropriately as a repair or an expense. If there are discrepancies between the classifications of past expenses and what they should be classified as today, you will need to make proper adjustments (Section 481(a) adjustments). 

Say you re-paint your rental in 2013 at a cost of $3,000. Prior to the new rules, you would need to depreciate this cost over 27.5 years as it is considered an improvement. However under the new rules, you can deduct the entire amount, so the good news is that the IRS will be owing you money.

If you replaced your roof and classified it as a repair, you may be in trouble. Under the new regulations, the roof replacement will be classified as an improvement, and you will need to be depreciating the cost rather than deducting the entire amount as you would with a repair. In cases like this, you will be owing the IRS, and perhaps a lot of money.

You will also probably have the option to deduct pre-2014 expenses that were previously not deductible, such as asset disposition and removal costs. 

That wraps up this blog post. I'd love to see some comments and questions. I hope you enjoyed the read and I look forward to hearing your thoughts and opinions. 

As promised, I have written a post on why you are likely required to file Form 3115. Click here to read the blog post.



Comments (45)

  1. To qualify for small taxpayer safe harbor regarding a rental income property the language is that the total paid for repairs, maintenance, improvements and similar activities does not exceed $10,000. Does similar activities include mortgage insurance? I am below the $10,000 if this does not include mortgage insurance but my total expenses on the Scheduled E exceeds $10,000 because that includes mortgage insurance.

  2. To qualify for small taxpayer safe harbor regarding a rental income property the language is that the total paid for repairs, maintenance, improvements and similar activities does not exceed $10,000. Does similar activities include mortgage insurance? I am below the $10,000 if this does not include mortgage insurance but my total expenses on the Scheduled E exceeds $10,000 because that includes mortgage insurance.

  3. A question on the de minimis safe harbor - the final regs indicate amounts would be deductible provided they constitute "an ordinary and necessary expense incurred in carrying on a trade or business." The IRS seems to have specifically left out income-producing activity, so does this mean a passive investor with rental property reported on Schedule E cannot take advantage of the de minimis safe harbor? No one seems to mention this anywhere. Interestingly, the small taxpayer safe harbor specifically includes income-producing activities, which leads me to believe the omission in the de minimis safe harbor is deliberate. Thoughts?


  4. Sorry about the four identical postings above but I could not tell if the comments had been posted.  Now I see that there is a time lag.   


  5. I have a property that is in need of having three large trees maintained at an expense of at least $650 each. The total will be about $1950. Must a portion of this tree trimming be depreciated? Or, can the total cost of trimming the three trees be expensed and simply deducted?

  6. I have a property that is in need of having three large trees maintained at an expense of at least $650 each. The total will be about $1950. Must a portion of this tree trimming be depreciated? Or, can the total cost of trimming the three trees be expensed and simply deducted?

  7. I have a property that is in need of having three large trees maintained at an expense of at least $650 each. The total will be about $1950. Must a portion of this tree trimming be depreciated? Or, can the total cost of trimming the three trees be expensed and simply deducted?

  8. I have a property that is in need of having three large trees maintained at an expense of at least $650 each. The total will be about $1950. Must a portion of this tree trimming be depreciated? Or, can the total cost of trimming the three trees be expensed and simply deducted?

  9. Thanks @Brandon Hall, very helpful information.

    On the SHST rule, I understand that one of the restrictions states:

    Annual Expenses Cannot Exceed the Lesser of $10,000 or 2% of the Building's unadjusted basis - When computing the annual expense amount, include every expense the building incurred during the year for repairs, maintenance, and improvements. Again, the beauty here is that you can make a capital improvement and expense it immediately rather than depreciate it as long as the annual expense falls within the limits described above.

    Regarding the $10,000 or 2% of the unadjusted basis cap of the total annual expenses the building incurred, I have a question. Let's say the 2% works out to be $6000.

    Does that mean ALL TOTAL EXPENSES on line 20 of SCHEDULE E for that property? Or total expenses mean the aggregated amounts of repair, maintenance and improvements?

    If it means line 20 of the SCHEDULE E, then property taxes, mortgage interests and insurance, legal fees, utilities are all part of that and if those alone exceeds $6000, then there is no room for anything else.

    So to clarify I would like to know what "EVERY EXPENSE THE BUILDING INCURRED" means. Only the repair/maintenance/improvement total costs in this context, or Schedule E line 20 total expenses.


    1. This is the exact question that I was just about to ask.  Thank you.


    2. Was this ever answered? 


  10. Could someone please define : "unadjusted basis" as pertains to Safe Harbor for Small Investors? Does it include the cost of land or only the building cost?


  11. Any new news re 3115?


  12. This just came out - reading through it now. There is relief!

    http://www.forbes.com/sites/peterjreilly/2015/02/1...

    http://www.irs.gov/pub/irs-drop/rp-15-20.pdf


    1. Phil, that irs link is to a too long and low information density doc. Can you give clear simple guidance? Tnx.

    2. Phil, that irs link is to a too long and low information density doc. Can you give clear simple guidance? Tnx.

  13. @Brandon Hall thank you so much for posting this, this is so much clearer than what I have read elsewhere. 

    In 2013, I bought several appliances for a new rentals, the appliances were bought after the rentals were placed in service by listing it for rent in MLS. Each appliance cost less than $500. This was in 2013, 1/5 of their value was depreciated for 2013. Can the remaining 4/5 be written off in 2014??


  14. @Tyson Cox good catch - I updated "personal" to say "tangible." The de minimis applies to personal properties and components acquired to maintain or repair a unit of tangible property (i.e. spare parts). As long as the expense falls under the $500 limit, and it meets the personal property or repair to tangible property requirement, you can likely currently deduct the expense.  


    1. Thanks for the reply Brandon. I do have another question regarding appliances and the example you use in the article:

      You own a $300,000 rental house placing your expense limit at $6,000. Your annual repairs and maintenance expenses are $2,000 and you installed new appliances totaling $3,500. Your total annual expenses for this rental property come in at $5,500 meaning you can utilize the SHST and currently deduct the entire amount. With old regulations, you would normally have had to expense the appliances and depreciate over a long period of time.

      Can the SHST be utilized for the $3500 for appliances? I have always been told that appliances are considered depreciable personal property. Can this be covered under the SHST rather than the De Minimis Safe Harbor? I ask this because I bought a fridge for a property for $600. The repairs and maintenance are under 2% of basis. I would like to deduct the fridge using SHST because it is over $500.

      I also have some tools that I would love to deduct rather than depreciate if at all possible. Value of items is $450 and $2100. I assume the $450 tool falls under the De Minimis Safe Harbor, but can the $2100 item be covered using the SHST?

      Thanks in advance for any imput you might have.


      1. *input

    2. *input

  15. @Brandon Hall
    What is considered "personal property" when dealing with rental properety? I have always been aware of appliances being considered personal property, but I didn't know windows could be considered personal property as in your example. Could you please clarify?

    Thx


  16. The 401k is tax exempt.   I think that's the key to circumventing the requirement for those properties.   The only form I file is a 5500-EZ, and that is only for 401k accounts with greater than 250K in assets as ours is.

    For the personally owned rentals, hmmm.....


  17. @Bob Ebaugh You and your CPA should still go back and look at expenses prior to 2014 to determine if you correctly categorized them as capital or non-capital. 

    Regardless of whether you have already done it correctly, you still need to file a 3115 as is law. I'm not sure how properties held in a 401k are impacted by this law.


  18. Thanks @Brandon Hall for posting this.   It's by far the clearest explanation on the internet for a semi-smart guy who has always done his own taxes.

    I am anxiously awaiting your post on the form 3115.   I only had one property placed in service prior to 2014, and it was in December 2013.   On that one I already capitalized everything claimed in 2013 except property insurance, so I don't think I have to ask for a change?

    Thank god most of our properties are in a 401K Trust, where I believe it escapes all this complexity.


  19. Sounds like all of use need to file 3115's?  Is there a reason for not filing 3115?  Is this per property?


    1. @Curt Smith Every person who owned a rental property in the U.S. prior to 2014 needs to file a 3115 with their tax returns this year. If you don't file, you will be breaking the law and should the IRS ever audit you, you may end up with hefty fines/penalties. 

      You can file one 3115 for all properties combined. 


  20. I agree thank you @Brandon Hall for taking the time to update us.


    1. Not a problem! Thanks for reading.

  21. Reading IRS regulations is not an enjoyable way of spending my time but increasing my awareness and understanding the reasoning behind them (on the occasions when there is logic behind them) makes me a better investor.  Thank you for sharing this.  


    1. Of course! Thanks for reading.


  22. This was GREAT information, @Brandon Hall ! Thank you for your timely post!


    1. Thanks @Stephanie W. !


  23. then there is this gem ...

    http://tprtoolsandtemplates.com/consequences-of-not-filing-the-required-tangible-property-regulation-3115s-by-tax-year-2014/


    1. Perfect! Thank you very much for the link. My next post will likely be revolving around filing a 3115.

  24. Thanks for the article...

    I own and self-manage an apartment complex with 24 buildings (16 4-plexes, 7 8-plexes, 1 12-plex).  I have an outstanding accountant who has already prepared me for these changes, but I just want to say that these new rules are ridiculous.  Dealing with taxes was already extremely complex and time consuming...and these types of changes just make it even more difficult for the small business owner to function in today's society.


    1. @Jimbob Bautista I wholeheartedly agree in that changes to tax law usually further complicate things causing more time and money to be spent working through it. The key is to have an accountant on your side who will help you navigate these waters as to avoid any sort of penalties - which is sounds like you have already done. 


  25. @Brandon Hall how do these new safe harbors relate to the rules about date placed in service for repairs to new purchases.  Before any repairs done to a newly purchased property before renting it out had to be included in the basis of the property.  Does this rule still apply?


    1. @Paul Ewing Repairs made prior to the property being placed in service (offered to the public for rent) are not currently deductible and are instead added to the basis of the property. So if you have repairs (especially cosmetic) you know you need to make, it may be wise to place the property into service and then make the repairs so that you can deduct them in the current year.

      If you are starting up a business, you can deduct repairs if they can qualify as start-up expenses. The limit is $5,000. 


  26. @Danae Meurer  You do apply it retroactively by filing Form 3115 - Application for Change in Accounting Method. Determine adjustments you need to make by utilizing the rules in this article, fill out Form 3115, and submit it to the IRS so they can approve your request for a change in accounting method. 

    The IRS now automatically approves 3115s and you only need to file one 3115 for multiple properties. You will file the 3115 with your tax return this year. Virtually everyone who owned rental property prior to 2014 that is still being depreciated today will need to file a 3115. It is now law and there are no exceptions. 

    You can amend tax returns by submitting IRS Form 1040X Amended U.S. Individual Income Tax Return within three years of filing the original return. If you have a 2011 return which you filed in 2012, you'd still be able to amend it this year. But for purposes of this blog post, the Form 3115 is going to be the form you want to file.


    1. We have always broken out the personal property from the building on our depreciation schedule.  When filing the 3115, will all the appliances that fall under $500 (the de minimus rule) simply be expensed?  And going forward, when we do the cost segregation for a new property, will everything that is under $500 for that property be expensed in the year it is placed in service?  


      1. @Danae Meurer Form 3115 allows you to currently deduct expenses you had been depreciating. So if those expenses fall under the de minimis rule, then yes you can currently deduct them on Form 3115.

        And yes, expenses under $500 can be currently deducted in the year of the invoice. So you no longer need to depreciate a $450 fridge since it falls under that $500 ceiling.  


      2. Regarding expensing appliances less than $500 that is good news. I am wondering if the $500 de Minimus Safe Harbor can be applied to the 2 toilets I just bought at $200 each for my apartment building?


      3. @Carol Agee De minimis only applies to personal property. A toilet is a fixture.


  27. As far as the regulations being retroactive in scope, does that mean we can amend all tax returns as long as they still fall within the 3 year limit?  I had seen somewhere else that you could go back to 2012, but it would be nice if we could amend 2011 still too.  Thanks.