Tax Strategies: Reducing Taxable Residential Rental Income
For landlords of residential rental properties, one of the most powerful tools in tax planning is the appropriate timing of major expenditures. Coupled with an understanding as to whether those significant costs are fully deductible in the year they are incurred, or expensed over 5 to potentially 27.5 years, can play a significant factor in the decision-making process for property owners. Due to the sweeping changes in tax law with the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) and the recent CARES Act, many of our clients have understandably been faced with confusion over this matter as there are elections for immediate expensing, accelerated depreciation methods, Section 179, Bonus depreciation, and the deduction for “qualified leasehold improvement property.” However, some of these highly touted laws are only available for commercial or non-residential rentals and selection of the most advantageous method for your situation can be difficult. How do you know which route to go?
First, do your residential rentals qualify as a business or are you an investor? This distinction will not only determine if you are eligible for the 20% QBI deduction but is also a factor in the ability to utilize some of these expensing methods. The determination itself is not discussed here but please see our article earlier this year titled, “20% Rental Real Estate Deduction – Is 250 Hour Safe Harbor Necessary?” (available at harriscpa.com)
This article will focus on Residential Rentals as Investors and we’ll try to break it down for you starting with elections. The IRS has provided taxpayers various elections that may provide immediate expensing.
De Minimis Safe Harbor Election (for tangible property)
This election removes the general requirement of capitalizing costs of acquired tangible personal property under $2,500 per item including furnishings, equipment, and supplies. The election is made by deducting these items as rental expenses on either Schedule E or Form 8825 (dependent on filing entity) and including a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" as an attachment to the timely filed original federal tax return (including extensions) for the taxable year in which the de minimis amounts are paid. The statement should include the taxpayer’s name, address, and Taxpayer Identification Number, as well as a statement that the taxpayer is making the De Minimis Safe Harbor election. This is a handy tool to allow immediate expensing of small items with less work than capitalizing and tracking depreciation.
Safe Harbor Election for Small Taxpayers
Repairs vs Improvements has been an issue of debate and consideration for longer than I care to remember. Basic repairs are always fully deductible in the year of payment when the price is reasonable and brings the asset back to its original state without increasing value. For example: repairing a portion of a roof or a leaking dishwasher, and replacing a damaged window, are fully deductible repairs, as they are basic maintenance expected to be made throughout the life of the asset. Improvements such as replacing an entire roof, upgrading appliances, and adding central air, add value to the structure, and will need to be capitalized and depreciated over their respective depreciable lives.
However, the distinction between an improvement requiring capitalization and a fully deductible repair can become muddled. Fortunately, the IRS allows residential landlords some relief from this issue in the form of IRS Reg. §1.263(a)-3h Safe Harbor for Small Taxpayers. The IRS has ruled that taxpayers with a) average gross receipts of $10 million or less; and b) own or lease building property with an unadjusted basis of $1 million or less; may elect to expense any and all repairs, maintenance, and improvements in any given year, as long as the collective total of said repairs, maintenance and improvements is less than 2% of the unadjusted basis of the property (up to a $10,000 annual limit per qualifying property). So, for example, if a taxpayer owned a $400,000 property, and properly made the Safe Harbor for Small Taxpayer election on their timely filed tax return, up to $8,000 ($400,000 x 2%) of repairs, maintenance and improvements could be fully deducted in the current year, without having to worry over whether or not their expenses should be classified as a capitalized improvement.
This Internal Revenue Code Section has been a highly favored tax law allowing trade or business owners to immediately expense up to $1 million in certain qualifying property (additional rules and limitations not discussed here). Before the TCJA residential rental property did not qualify for deduction under Internal Revenue Code Section 179. Under the expanded section 179 rules some residential rental property could be eligible but – you must be in the business of renting residential rental property not an investor. Additionally, you must have taxable income from the business to utilize this deduction, so the expanded provision is not as useful as it sounds. Section 179 may not be taken on real property such as buildings and land, and the expansion of the code section to include interior improvements only applies to non-residential rentals.
Bonus depreciation allows for immediate 100% expensing of depreciable assets through 2022 and, for residential rentals, can be used on property with a depreciable life of less than 20 years. That includes carpeting, appliances, equipment, and land improvements such as parking lots and curbing. Also, there is no net income requirement for bonus depreciation which allows taxpayers with typically lower profits or rental losses access to accelerated depreciation. There are drawbacks, however, with bonus depreciation being unavailable for purchases of used items, as well as many states (including Idaho) disallowing bonus depreciation, which forces taxpayers to add back the accelerated depreciation deduction on their state return as income. We typically recommend that taxpayers elect out of bonus depreciation if their rental activities will be subject to passive loss limitations.
For capital assets that do not qualify for immediate expensing, an understanding of the number of years an expenditure will be depreciated over could sway a taxpayer to either delay or expedite a purchase. For example: A $10,000 invoice for new carpeting could potentially be entirely expensed in the current year under the Safe Harbor for Small Taxpayers, assuming requirements have been met, but, if the election is not an option in a given year, bonus depreciation could be the answer. If the taxpayer balks at the idea of bonus depreciation due to the state add back, that $10,000 carpet will be deducted over the next 5 years instead. The following is a list of common residential rental purchases and their depreciable lives:
- 5 years: Carpeting and vinyl, office equipment, computers, appliances, cabinetry, vehicles, rental furniture and fixtures
- 7 years: office furniture and fixtures
- 15 years: fencing, shrubbery and landscaping, parking lots, stairways
- 27.5 years: HVAC units, air conditioners, roofs/gutters, remodeling/renovation expenses, buildings
With such a large variance in depreciable asset lives and the multiple tax laws affecting your tax liability, it is of the utmost importance that taxpayers be aware of all options available to them to facilitate tax planning decisions. If you have any questions, please feel free to reach out to our tax professionals at B.A. Harris
Aaron Lavarias, CPA and Arla Kester, CPA
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