Due to either PCS moves or deliberate investing, many military members become landlords. While this can be a great way to build wealth, it also comes with new tax challenges. In particular, when paying for repairs, people frequently ask whether they should capitalize or deduct for tax purposes. As such, we’ll use this article as a playbook: capitalize or deduct – reporting repairs for military landlords.
Specifically, we’ll discuss the following:
- Military Landlords and Home Repairs
- Real Estate Taxes: Capitalize vs Deduct
- When Should I Capitalize Repairs?
- When Should I Deduct Repairs?
- Final Thoughts
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Military Landlords and Home Repairs
The VA loan provides eligible service members and veterans a low-cost home-buying option. And, when military members move after buying a home, they often decide to become a landlord. Rather than sell recently purchased homes, they convert them into rental properties. Alternatively, many military members opt for a more deliberate real estate investing track, buying rental properties in every duty station.
Regardless of how you acquired your rental properties, being a landlord comes with one inevitable challenge: home repairs. Through wear and tear or just downright neglect, you’ll eventually need to pay to fix something at a rental property.
New landlords typically believe that if they repair something, they can deduct this from their taxes. But, the tax treatment isn’t always so clear cut in the eyes of the IRS. Depending on what sort of work you complete, you’ll either 1) capitalize the costs, or 2) deduct the costs. Both of these options will have different impacts on your taxes, and we’ll discuss these differences in the next section.
Real Estate Taxes: Capitalize vs Deduct
Capitalized Costs
When you capitalize a cost, you gain a smaller tax benefit over time rather than a large one immediately. In technical terms, capitalizing a cost adds that cost to your rental property’s taxable basis, and you depreciate it over time.
For example, assume that you replace a damaged roof for $25,000. This roof replacement qualifies as a restoration (which we’ll discuss below), meaning that you capitalize the cost. Instead of using all $25,000 to reduce your current year’s taxable income, you use a portion of that $25,000 every year to reduce future taxable income. Conceptually, the IRS argues that the benefit you receive from that new roof will last more than one year. Accordingly, the tax benefit you receive will also last more than one year.
NOTE: The IRS uses a schedule known as MACRS to determine the depreciation period for certain property. For residential real estate and associated capital improvements (e.g. a roof replacement), the IRS uses a 27.5-year depreciation period. This means that you would reduce your taxable income by $909 every year to depreciate the roof installation ($25,000 capitalized cost / 27.5 years).
Deductions
Deductions, on the other hand, provide an immediate and total tax benefit. That is, you can use 100% of deductible costs to reduce your current taxable income.
For example, say you pay $500 to complete annual maintenance on your HVAC system to ensure it remains in good working order. This routine maintenance (discussed below) qualifies as a deductible expense – not a capital one. As a result, you can use that entire $500 to reduce your current taxable income. That is, you do not need to capitalize and depreciate that $500 over an extended period of time.
What Should I Do?
As these examples illustrate, deducting provides far more immediate tax benefit than capitalizing costs. But, military landlords can’t simply deduct a cost, just because it provides a larger tax benefit. Rather, you need to follow specific guidance outlined by the IRS as to when you should capitalize repairs, and when you should deduct them.
When Should I Capitalize Repairs?
In IRS parlance, capitalizing vs. deducting comes down to distinguishing capital improvements from deductible repairs. Property has been improved (as opposed to repaired), if the amounts paid are:
- For a betterment to the unit of property; or
- To restore the unit of property; or
- To adapt the unit of property to a new or different use.
In other words, if property has been bettered, restored, or adapted to a new or different use, landlords must capitalize those costs. But, recognizing that this still remains confusing, the IRS has provided further guidance as to what, exactly, it means to better, restore, or adapt to a new or different use:
Betterments
- Amounts paid to fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property; or
- Amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component, to the property or a material increase in capacity, including additional cubic or linear space, of the unit of property; or
- Amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property where applicable.
NOTE: The IRS doesn’t actually define the term “material” in the context of betterments. Accordingly, the final guidance states that: you should use common sense and reasonable judgment as applied to your own facts and circumstances.
Restorations
- Replacement of a major component or substantial structural part – Amounts paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or
- Deterioration to state of disrepair – Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or
- Rebuilding to like-new condition – Amounts paid for the rebuilding of the unit of property to a like-new condition after the end of its class life.
Adaptations
- An amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with your ordinary use of the unit of property at the time you originally placed it in service.
When Should I Deduct Repairs?
From the thorough guidance regarding capitalized improvements, it may seem like the IRS doesn’t want you to deduct anything. But, IRS rules clearly state that routine maintenance qualifies as a deductible expense. In particular, you are not required to capitalize as an improvement, and therefore may deduct, amounts that meet all of the following criteria:
- Amounts paid for recurring activities that you expect to perform;
- As a result of your use of the property in your trade or business;
- To keep the property in its ordinarily efficient operating condition; and
- You reasonably expect, at the time the property is placed in service, to perform the activities:
- For building structures and building systems, more than once during the 10-year period beginning when placed in service, or
- For property other than buildings, more than once during the class life of the unit of property.
IRS Safe Harbor Rules
But, even with that guidance on routine maintenance, military landlords may question whether a certain cost qualifies as a deduction or an expense. Recognizing this potential for confusion, the IRS has created “safe harbor” rules that, if followed, let landlords deduct all costs under certain monetary thresholds.
Specifically, the IRS’ Safe Harbor Election for Small Taxpayers states that: “You are not required to capitalize as an improvement, and therefore may be permitted to deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers. The requirements of the safe harbor election for small taxpayers are”:
- Average annual gross receipts of $10 million or less; and
- Owns or leases building property with an unadjusted basis of less than $1 million or less; and
- The total amount paid during the taxable year for repairs, maintenance, improvements, or similar activities performed on such building property doesn’t exceed the lesser of-
- Two percent of the unadjusted basis of the eligible building property; or
- $10,000
For most military landlords, this safe harbor effectively allows you to deduct up to $10,000 in costs annually, regardless of whether those costs would normally qualify as capital improvements or deductible repairs.
Final Thoughts
As with most tax issues, the IRS doesn’t make figuring out whether to capitalize or deduct repairs easy. But, by following the above guidance and safe harbor rules, military landlords can A) maximize their current year tax deductions, while b) complying with IRS rules on capital improvements. Having said that, if unsure how to treat a certain rental property cost, you should seek the advice of a tax professional.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.
