Tax Rules for Deductions on Repairs and Maintenance
Your small business may be eligible for one of the IRS 'safe harbor' rules
Sole proprietors, businesses, and rental property owners can deduct expenses for repairs and maintenance of their property and equipment. But the IRS tightened up the rules for how repairs and maintenance expenses are deducted with a set of new restrictions, effective since 2014.
In general, if a repair makes equipment better, restores the property to its normal condition, or adapts the property for a new or different use, then the expense is capitalized and depreciated over several years. Repair and maintenance expenses that do not fall under the categories of "betterments," restorations, or adaptations can be deducted in full in the year the expense was paid.
"If you repair stuff, you can deduct it," says Steve Nelson, a certified public accountant who has written extensively about deducting repairs on the Evergreen Small Business blog. "If what you do is a betterment, restoration or adaptation," Nelson says, "the new rules say we're going to make you capitalize it and depreciate it unless it's such an amount that it's small potatoes."
Routine Repairs and Maintenance Can Be Deducted Right Away
"Generally, you can deduct amounts paid for repairs and maintenance to tangible property if the amounts paid are not otherwise required to be capitalized." That's according to IRS.gov, Publication 535, Business Expenses, chapter 7, section on Repair and Maintenance Costs.
So, when is it a capital expense and when is it a deductible expense? In another section of Publication 535, the IRS clarifies the issue:
"Repairs. The cost of repairing or improving property used in your trade or business is either a deductible or capital expense. Routine maintenance that keeps your property in a normal efficient operating condition, but that does not materially increase the value or substantially prolong the useful life of the property, is deductible in the year that it is incurred. Otherwise, the cost must be capitalized and depreciated." (IRS.gov, Publication 535, Business Expenses, chapter 11, section on Repairs)
Here the IRS defines what it means by "routine maintenance." It "keeps your property in a normal efficient operating condition." An example would be changing the oil on a car. It keeps the car operating normally and efficiently, but doesn't substantially prolong the useful life of the car. Replacing the transmission, however, would definitely prolong the useful life of the car, and so would likely need to be capitalized.
Capitalizing Repairs and Maintenance: The "BRA" Test
Repairs and maintenance costs that make a property better, restore it to working condition, or adapt it to a new use need to be capitalized and depreciated over several years. One way to remember this concept is the BRA test, a mnemonic coined by Tony Nitti that refers to betterments, restorations, and adaptations.
Betterments are repairs intended to make something better than it was before. Specifically, repairs fall under the category of betterments if they:
- Fix a defect that existed before you bought the property.
- Fix a defect that happened while the property was being made.
- Enlarge or expand the property so that it has more capacity.
- Increase the property's quality, strength, efficiency, or productivity.
For more details, see the "What Is a Betterment?" section of the Tangible Property Final Regulations Q&A from the IRS.
Restorations are repairs that restore something to its normal condition. Fixing a roof or replacing it entirely are examples. Specifically, repairs fall under the category of restorations if they:
- Restore deteriorated property to its "ordinarily efficient operating condition."
- Replace a major component or substantial structural part of a piece of property.
- Rebuild the property to like-new condition.
- Result in a deductible loss, sale or exchange, or casualty loss treatment for the property or component of the property.
For more details, see the "What Are Amounts to Restore a Unit of Property?" section of the Tangible Property Final Regulations Q&A from the IRS.
Adaptations are repairs that change how the property or equipment is being used. Suppose a building owner converts a factory into a showroom. How the building is being used changes from manufacturing to retail. Any repairs related to adapting the property are capitalized.
Specifically, the IRS says an adaptation expense 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" (from the "What Adapts the Unit of Property to a New or Different Use?" section of the Tangible Property Final Regulations Q&A from the IRS).
Three Safe Harbor Rules
The general rule is that expenses for repairs and maintenance need to be capitalized and depreciated, but there are three exceptions. The IRS calls these safe harbors. But even with a safe harbor, one cannot just write off the expense. The IRS expects taxpayers to make a formal choice, called an "election," by attaching an election statement to their tax returns.
A safe harbor for small invoices.
A person or business can immediately deduct repair and maintenance expenses if the cost is $2,500 or less per item or per invoice. A business with an "applicable financial statement," however, has a safe harbor amount of $5,000.
A safe harbor for small projects.
Repairs can be deducted immediately if the total amount paid for repairs and maintenance on the property is $10,000 or under, or 2 percent of the unadjusted basis of the property, whichever amount is lower. This safe harbor is only available for businesses with revenues under $10 million and when the property being repaired has an unadjusted basis under $1 million. For more details on this provision, see the safe harbor election for small taxpayers section of the Q&A on the IRS website.
A safe harbor for routine maintenance.
If the repairs consist of routine maintenance, the repair expenses can be deducted immediately. The IRS has spelled this out in some detail. For routine maintenance to be immediately deductible, the IRS wants the expense to satisfy all four of the following criteria:
- The repairs are regularly recurring activities that you would expect to perform.
- The repairs result from the wear and tear of being used in a trade or business.
- The repairs are needed to keep the property operating efficiently in its normal condition.
- The repairs are expected to be necessary more than once during a 10-year period (for buildings and structures related to buildings), or more than once during the property's class life (for property other than buildings).
Class life refers to the number of years over which the IRS expects property to be depreciated. This is outlined in Publication 946, How to Depreciate Property, especially the property class section of chapter 4 and Appendix B.
A word of caution: The routine maintenance safe harbor does not apply to expenses that fall under the category of betterments.
Suppose a landlord replaces a roof on a rental property. When the property was placed in service as a rental, the cost of the property was split into two: land and building. The land is a nondepreciating asset. The cost of the building was capitalized and depreciated over a period of years (27.5 years for residential real estate or 39 years for commercial real estate). Thus the cost of the old roof is included in the cost of the building and is being depreciated over time.
Now the landlord replaces the roof. This type of restoration needs to be capitalized and depreciated (over 27.5 years or 39 years, as applicable). So now the landlord has two assets being depreciated: the original building and the new roof. But the old roof is included in the building. So, in a way, the landlord is depreciating an asset (the old roof) that no longer exists. In this scenario, the IRS allows the landlord to make a partial disposition. In essence, the landlord can write off the cost of the old roof, thus removing that part of the cost from the building's depreciation schedule.
What's the benefit? There's an immediate deduction for the old roof, which offsets the downside of having to depreciate the new roof over several years. An added bonus: "There is no depreciation recapture because there was no sale or exchange," says Phil Zaman, a director in the CBIZ National Tax Office. Partial dispositions thus result in less accumulated depreciation to recapture if the property is sold in the future.
In order to properly determine what can be deducted and what has to be capitalized, you need to review what the expense is, how much it cost, and how the expense relates to the property being repaired or maintained.
For each repair or maintenance expense, you should:
- Review the invoice for the expense.
- Apply the BRA test: Is the expense a betterment, a restoration, or an adaptation?
- Review the expense. If the total invoice is $2,500 or less, consider using the de minimis safe harbor. The Latin phrase denotes something insignificant. Is the amount $10,000 or less? Equal to or less than 2 percent of the unadjusted basis of the property being repaired? If so, consider using the safe harbor election for small taxpayers.
- Consider the nature of the repair. Is it an expected and necessary part of keeping the property in ordinarily efficient operating condition? If so, consider using the safe harbor for routine maintenance.
- Consider whether it is possible to write off a "partial disposition."
- Capitalize any expenses as needed and set up a depreciation schedule for writing off the repair expense.