Rental Repair or Improvement: Water Heater, Roof, Flooring

Is replacing a water heater, roof or flooring in a rental a repair to deduct or an improvement to capitalize?

Publication 527 lists a water heater, a new roof, flooring and wall-to-wall carpeting as improvements. An improvement is capitalized: added to the property's cost and deducted over many years as depreciation. Work that only keeps the property in ordinarily efficient operating condition is a repair, deducted when paid (Schedule E instructions). A safe harbor election can still turn an improvement into a deduction this year.

Questions to ask, in order. Is it a repair, such as a worn part or a patch? If it looks like an improvement, is the invoice within $2,500, is the year's work on the building within the small taxpayer limit, or is it routine maintenance? If none fits, it is depreciated.

When a case is not simple. Several jobs on one building in a year, one job split across invoices, repairs mixed into a renovation, work after a storm, fire or flood, several buildings or a partnership, or earlier years with no asset list or election on file. The de minimis and small taxpayer safe harbors are elections made on the return, so they are decided before filing, extensions included.

What to gather. Itemized invoices (parts, labor, installation); the date each item was ready for use; photos and notes of what was replaced and how much; the building's purchase or other basis records without the land, with earlier capitalized improvements; earlier depreciation schedules.

How does the IRS tell a repair from an improvement?

An expense is an improvement if it is a betterment, a restoration or an adaptation (regulation); other work that keeps the property in working order is a repair. For a building, the test is applied separately to the building structure and to each building system: plumbing, electrical, heating and cooling, elevator, escalator, fire protection and alarm, gas distribution and security (IRS tangible property rules).

The regulations leave "material" undefined; the IRS says to use reasonable judgment on your facts (IRS tangible property rules).

Is a water heater replacement a repair or an improvement?

Publication 527 lists a water heater as an improvement, so replacing the whole unit starts out capitalized. Replacing a worn part with a comparable part is generally repair-type work. The regulation lists pipes, drains, valves, sinks, bathtubs and toilets as examples of the plumbing system and does not mention water heaters, so Publication 527's list is the IRS's published starting point.

Whether the cost is still deductible turns on the safe harbors below, or on the regulation's test for replacing a major component of a building system. That test has no water heater example: replacing one furnace of three was not a restoration, but replacing the one chiller that cools a building's whole system was (regulation).

Is a new roof, or a roof patch, a repair or an improvement?

Patching a small section of a roof is a repair. Publication 946 says completely replacing a roof makes the new roof an improvement, a restoration of the building, and it is depreciated. The regulation treats a whole roof as both a major component and a substantial structural part of a building; its example replaced the decking, insulation and coatings.

The regulation's examples are commercial buildings. Replacing only a worn waterproof membrane with a comparable one was not a restoration, and another example assumes the same for worn shingles replaced to stop leaks. A pitched house roof can fall on either side, depending on how much is replaced and why.

Is new flooring an improvement, and what if I replace only a damaged section?

Publication 527 lists flooring and wall-to-wall carpeting as improvements. Under the regulation, all of a building's floors together are a major component, and replacing only a small part of them is not a restoration. In its hotel examples, new lobby floors (under a tenth of the building's area) were not a restoration, while new floors in all public areas (about two-fifths) were. It sets no percentage. Carpet is a five-year item in a rental, not a structural component (Publication 527), so this floor test fits hardwood, tile and other permanent flooring best.

A betterment is tested against the condition before the wear or damage, so matching the old floor is less likely a betterment than upgrading the grade. The material changes the depreciation class, covered below.

Which safe harbor applies: by invoice, by building or by recurrence?

Three safe harbors can allow a deduction for work that would otherwise be capitalized. They can be used in the same year, and amounts under the de minimis and routine maintenance safe harbors still count toward the building total in the small taxpayer safe harbor (regulation).

Can I deduct it under the de minimis safe harbor?

An invoice or item within $2,500 can be deducted instead of capitalized if the landlord makes the yearly election and expenses the amount in the books. The limit is for a landlord without an applicable financial statement, such as audited financial statements (regulation; IRS notice raising the limit).

• Per invoice or item. Delivery and installation on the same invoice count toward the cost.
• Election and books. A yearly statement attached to the original return filed on time, extensions included, covers every qualifying amount that year and cannot be revoked; a partnership makes it for itself. The amount must also be expensed in the books under a consistent policy that existed at the start of the year (IRS FAQ). The statement's wording and what to do if it was missed are in expensing or capitalizing small purchases.
• Over the limit. The invoice goes through the repair-or-improvement test; it is not automatically capitalized.
• Splitting invoices. An anti-abuse rule covers invoices created to break up property usually bought as one unit, to get under the limit.

What is the small taxpayer safe harbor, and when does a big year of work lose it?

The safe harbor lets a landlord deduct all repairs, maintenance and improvements on one building in a year if the year's total stays within the lesser of 2% of the building's unadjusted basis or $10,000. If the total goes over, the safe harbor is lost for that building for the whole year, not only the excess (regulation).

• Receipts. Average annual gross receipts for the three preceding years of $10 million or less. Rent counts as gross receipts.
• Building size. An unadjusted basis of $1 million or less: the building's tax basis ignoring depreciation, without the land. That is usually cost, plus earlier capitalized improvements, but a gift or inheritance sets a different starting basis (regulation). For the land and building split, see closing statement in the books.
• Everything counts. Repairs, maintenance and improvements, including amounts covered by the de minimis or routine maintenance rules. Each building is tested alone.
• The election. A statement titled "Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers", with name, address, taxpayer ID and a description of each building, attached to the original return filed on time. It cannot be revoked. A partnership makes it for itself. A missed election has only narrow late relief, which the regulation sends to the IRS's extension rules, so make it with the return.

What is routine maintenance, and what counts as routine?

Routine maintenance is recurring work that keeps a building or one of its systems in ordinarily efficient operating condition, and that the owner reasonably expected, when the building or system was placed in service, to do more than once in 10 years. It needs no election and does not cover betterments (regulation; IRS tangible property rules).

Inspection, cleaning, testing and replacing worn parts with comparable parts can qualify. In the regulation's examples, handrails expected to need replacing every four years qualified; steps expected to last 18 to 20 years did not. A one-off replacement of a whole roof or water heater seldom meets that test. Work needed because of the previous owner's use, or to revive a neglected property, is not routine maintenance.

If a repair is done during a larger renovation, does it have to be capitalized too?

It does when the repair directly benefits the improvement or is done because of it, and it does not when the repair is unrelated, even if done at the same time (regulation). A patch to the roof section being replaced belongs to the roof job. A leaking faucet fixed the same week in another room does not. Itemized invoices let each cost be placed when the work is unrelated.

If I capitalize it, how is it depreciated, and when does it start?

A capitalized improvement is depreciated as its own asset over the recovery period of the property it improves (Publication 527). The table shows the usual General Depreciation System periods. The Alternative Depreciation System has longer ones and is required for residential real property held by a real property trade or business that elected out of the business interest limit (Publication 946); then the schedule must follow that election.

Floors and permanent coverings such as tiling are structural components of a building (Publication 946). Publication 527 lists a water heater under plumbing and puts furnaces and waterpipes with the building, but it also lists stoves and refrigerators as five-year appliances and does not say which class a water heater is. The class decides the recovery period, so it should be settled before the first year is filed.

• Start. Depreciation begins on the later of the date the improvement is placed in service or the date the building was. Property is placed in service when it is ready and available for use, even if unused. For a building improvement, the first year counts only the months in use.
• Special allowance. Five-year items such as carpet and appliances can qualify for 100% bonus depreciation, which Form 4562 calls the special depreciation allowance, in the first year, if they meet the acquisition and in-service dates in the Form 4562 instructions, unless the owner elects out for that class. Qualified property has a recovery period of 20 years or less, so improvements to a residential rental building do not qualify. For the rules, see writing off equipment in the first year.
• The old part. An original roof or floor in the building's basis keeps depreciating after a replacement unless the owner makes the partial disposition election: report the loss on the original return filed on time, extensions included, for the year the old part was disposed of, even if the new one is installed later. It can be revoked only with IRS consent. Taking the loss also makes the replacement a capitalized restoration. A fully retired, separately capitalized earlier improvement stops depreciating without the election, and a casualty disposal has its own rule (regulation).

Where do repairs and depreciation go on the return, and what do I keep?

On Schedule E, repairs go on line 14 and depreciation on line 18. Form 4562 is attached when depreciation is claimed on property placed in service during the year (Schedule E instructions). De minimis items go on line 19 (Publication 527). A partnership reports rental real estate on Form 8825, with depreciation on line 14 (Form 8825 instructions). Safe harbor elections are statements attached to the return, not boxes on a form.

Publication 527 says to separate repairs from improvements and keep accurate records, because improvement costs are needed to depreciate and to sell. Keep the items listed at the top, an asset list (cost, date, class) and a copy of each election statement. For cash repairs without invoices, see rental property records and receipts.

Example

These examples use federal rules and US dollars. Figures are illustrative. No landlord has an applicable financial statement. Each de minimis deduction assumes a timely election and a policy, in place on the first day of the year, to expense purchases under US$2,500, followed in the books. Average gross receipts are far below the small taxpayer limit.

Water heater in an Ohio rental

A landlord pays US$1,150 to replace a water heater. The de minimis election is made for the year and the amount is expensed in the books, so on these facts the cost is deducted. A second landlord pays US$3,400 for the same job, with no election and no other safe harbor. Following Publication 527's list, the cost is an improvement and is depreciated.

Roof on a duplex

A duplex has a building basis of US$220,000. The small taxpayer limit is the lesser of 2% (US$4,400) or US$10,000, so US$4,400. A US$800 repair to a porch step fits on its own. A US$14,000 replacement of the whole roof in the same year brings total work to about US$14,800, over the limit, so the safe harbor is lost for the building. On these facts the roof is a restoration: capitalized and depreciated over 27.5 years, about US$509 a year after the first year. The US$800 step repair, unrelated to the roof, is still a repair.

A turnover year

Two single-family rentals turn over in one year. In the first, laminate for one bedroom is US$2,300 on one invoice. It is within the per-invoice limit, so with the de minimis election it is deducted. In the second, US$6,800 of hardwood replaces the floors throughout the house. It is over the limit and covers most of the building's floors, so it is likely capitalized and depreciated with the building, unless the building's work for the year fits the small taxpayer limit. Splitting it into small invoices only to get under the limit can be challenged.

Different for you?

• Several rentals or a big renovation year, with no asset list or election on file: The year's work has to be sorted building by building and invoice by invoice, and elections are made only on the return. Earlier years may need correcting too. For the return, see individual tax help; for recording each job as it is paid, bookkeeping.
• Past years were all deducted as repairs, or all capitalized: What fixes it depends on how many returns used the treatment. One filed return is usually not yet an accounting method (26 CFR 1.446-1), so amending may fix it. Repeated across returns, it can become a method, and changing it then needs the IRS's consent, usually through Form 3115 rather than an amended return (IRS tangible property rules). For depreciation, Publication 946 puts the line at two or more consecutive returns. See missed depreciation, rebuilding a depreciation schedule, catching up rental books and individual tax help.
• The work followed a storm, fire or flood, or an insurance claim: When basis was adjusted for the loss, repairing the damage is capitalized as a restoration. The special limit, tied to the property's adjusted basis, caps only costs capitalized under that casualty rule; a whole-roof replacement stays capitalized above it (regulation). See individual tax help.
• The rental has no tenant yet: see rental expenses before the first tenant.
• You live in part of the building or use the rental yourself: only the rental share of a whole-building cost counts (Publication 527). See fair rental days and personal use.
• The rentals sit in a partnership, or an LLC taxed as one: the partnership makes the elections and reports on Form 8825; see books for an LLC per rental property.
• You are a nonresident owner, such as a Canadian with a US rental: the return and its filing rules differ. See nonresident landlords and Canadians with US rental property.
• You are selling the rental: see depreciation recapture and the closing statement in the books.
• The purchase is business equipment, not a rental: see writing off equipment in the first year.
• You want the full rental picture: see rental property taxes.