Note: Article written by Stephen Michael White, the co-founder and CEO of RentPrep, a company of solutions and tools designed to help landlords succeed. He is a frequent speaker for real estate and landlord associations around the country, passing along the knowledge he’s gained working with over 10,000 landlords, investors and property managers. 

The IRS guidelines on tax deductions for real estate investors are notoriously complex, with a lengthy and intricate method of determining depreciation for expenses from improvements, renovations and repairs on your tax return. However, a new regulation that went into effect on January 1, 2014 now makes it easier for you to deduct qualifying expenses instead of depreciating them. IRS Reg. 1.263(a)-3h, known as “safe harbor for small taxpayers,” is definitely an advantage for those who own investment properties.

What’s New?

Until this new regulation, real estate investors had to complete lengthy and complicated paperwork that involved depreciation of property improvements over a number of years. You were forced to justify whether an expense was a repair, an improvement, or other category, and decipher how the IRS wanted you to treat that expense.

Under this new law, you are now able to deduct qualifying expenses for improvements, renovations, repairs and upgrades. The result is an immediate impact on the amount of taxes you pay, rather than waiting for the impact over a dozen years due to depreciation. Examples of expenses that qualify include replacing damaged or worn systems, cost of inspections, improving the property with energy efficient upgrades and expenses used to bring a property up to code. However, not every real estate investor’s expense list will qualify.

How It Works

The IRS has set up restrictions on who can take advantage of the safe harbor. It is designed to deliver the most benefits to small to mid-size real estate investors, allowing those who qualify to take a direct deduction from taxable income. Note that the deduction limits apply on a building-by-building basis.

Here is how to determine if you and your property qualify:

– Verify that your gross receipts total less than $10 million over the past three years and your property cost is less than $1 million.

– Calculate the total amount of the past year for maintenance, improvements and repairs. If the total is less than $10,000 you may be eligible. If it exceeds $10,000, you do not qualify.

– Figure the base cost of your building and calculate 2 percent of that.

– Choose the lesser of the two figures from step 2 and step 3.

– If your total expenses for repairs, upgrades and improvements are lower than the lesser figure, you are eligible for deduction. If they are more, you are not eligible.

To take advantage of this new rule for 2013 tax returns, you must keep track of annual expenses for improvements, repairs and maintenance for the entire 2013 year. When it is time to file your taxes, you will need to fill out an election form. Assuming you qualify, you will be able to deduct the entire amount of the expenses from your 2014 tax return.

The new law also allows property owners like you to apply the deduction retroactively for the previous two years (2012 and 2013), so if you have completed major repairs, upgrades or other improvements recently, it might be well worth it to amend those tax returns and see if the safe harbor affects your returns in your favor.

Applying Safe Harbor

Here are some scenarios to demonstrate whether the safe harbor applies to specific real estate investors and property owners.

Example A: If Jeanette owns a rental property (cost is $400,000) and made improvements to the property that totaled $5,500, she would qualify for safe harbor and deduct the entire amount. This is because the property costs less than $1 million, her gross earnings were less than $10 million over three years and the total expenses she is claiming were less than $10,000 and 2 percent of the building’s cost ($400,000 x .02 = $8,000). Jeanette can deduct the entire $5,500 on her 2014 tax return.

Example B: Thomas’ rental property has a $275,000 unadjusted basis and he spent $9,300 on improvements and repairs in 2013. Thomas is not eligible for the safe harbor, even though his gross receipts are under $10 million and the property is worth less than $1 million. Thomas may seem to qualify to claim the deduction because the amount he wishes to claim is less than $10,000. However, his repairs and improvements exceed the 2 percent ($275,000 x .02 = $5,500). The regulation states that the taxpayer must go with the lesser amount ($10,000 or $5,500, in this case). Therefore, he cannot deduct the amount using the new regulations. There are other ways to include the cost of improvements on the tax return it, but Thomas does not qualify for safe harbor.

For those of you who are constantly seeking out ways to reduce the income tax on the profits from your real estate business, the new IRS Reg. 1.263(a)-3h will be a welcome change. It lets qualified real estate business owners like you avoid the complicated IRS regulations on deducting improvements and repairs to business property and opt for the more immediate benefits.