Determining the proper tax treatment for specific residential rental property expenditures can be time-consuming. The tax deduction rules for residential landlords have changed dramatically from 2013 to 2018. Landlords are now much more likely to be able to deduct most of their current expenditures. This discussion is intended to provide a road map for making the correct determinations and elections.
Determining the character of expenditures
The starting point is to determine whether the expenditure is for a betterment, restoration, or adaptation. For example, expenditures related to a comprehensive remodeling or correcting a preexisting defect would be for a betterment or restoration and will need to be capitalized. The mortgage interest and property taxes incurred during construction may need to be capitalized as well. (For more on betterments, restorations, and adaptations, see the IRS's Tangible Property Regulations FAQs, available at www.irs.gov.)
If the expenditure is not a betterment, restoration, or adaptation, the next step is to determine whether the expenditure can be expensed under the de minimis or routine maintenance safe-harbor elections. The de minimis and small taxpayer safe-harbor elections apply to businesses and farms as well as to rental properties.
De minimis election
Under the tangible property regulations and Notice 2015-82, expenditures for tangible property that would otherwise be capitalized can be expensed if the item costs $2,500 or less and the taxpayer makes the proper election. Taxpayers with applicable financial statements have a de minimis cap of $5,000 per item. The taxpayer makes the election annually by including a statement with the tax return citing "Section 1.263(a)-1(f) de minimis safe-harbor election." The election is made in the year the tangible personal property is placed in service and is allowed in any year of ownership.
Small taxpayer safe-harbor election
Landlords with gross receipts of $10 million or less and whose unadjusted basis in each property is $1 million or less can elect to write off repairs, maintenance, and improvements if the total of these expenditures does not exceed the lesser of 2% of the unadjusted basis of the property or $10,000 during a given year. Items deducted under the de minimis election are also included in the routine maintenance safe-harbor calculation (Regs. Sec. 1.263(a)-3(h)(2)). The taxpayer makes the annual election by including a statement citing "Sec. 1.263(a)-3(h)(1) Safe Harbor Election for Small Taxpayers," along with the name, address, and ID number of the taxpayer and a description of each eligible building property for which the election is being made. The election can be made on a building-by-building basis.
Routine maintenance safe harbor
Recurring expenditures for repairs and maintenance that keep property in ordinarily efficient operating condition do not need to be capitalized and can be expensed in the year payment is made. However, they are included in the 2%/$10,000 small taxpayer safe-harbor calculation. No elections are required. See the table "Typical Repairs and Maintenance Expenditures" for examples of expenses that fall into this category.
Sec. 179 does not apply to residential rental property or any of its components or improvements or to other property used in conjunction with the rental property.
For property placed in service after Sept. 27, 2017, 100% bonus depreciation is available for components with a recovery period of 20 years or less. Consideration should be given to depreciating versus expensing if the property is profitable and the taxpayer qualifies for the Sec. 199A qualified business income (QBI) deduction, because the unadjusted basis of depreciable property is included in the Sec. 199A deduction calculation.
Typical deductions and depreciable life according to Sec. 168(c) are shown in the table "Depreciable Life of Certain Components."
Sec. 199A: Deduction for qualified business income
In January, the IRS released Notice 2019-07, which provides safe-harbor requirements for rental real estate to qualify as a trade or business under Sec. 199A. To qualify, the real estate must be owned directly or through a disregarded entity. Additional requirements to meet the safe harbor are as follows:
- Separate books are maintained for each real estate enterprise;
- Annually, at least 250 hours of rental services are provided by the owner, agent, or contractor; and
- Contemporaneous records, including time reports, logs, or similar documents are maintained that show the hours worked, a description of the service, the date, and who performed the service.
The notice also states that rental real estate businesses that do not meet the safe-harbor requirements may still qualify for the Sec. 199A deduction if they meet the definition of a trade or business under Sec. 162 other than the trade or business of performing services as an employee (Regs. Sec. 1.199A-1(b)(14)). Specifically excluded from the safe harbor are residences used by the taxpayer during the year and real estate leased where the tenant pays all the costs of ownership, commonly called triple net leases. The safe-harbor rules are effective for tax years ending after Dec. 31, 2017.
If the activity does not meet the safe-harbor requirements, the key is whether it rises to the level of a trade or business, rather than an investment activity. There is no definition of "trade or business" in the Code. However, the courts have held that activities with a profit motive and with continuous and regular involvement by the taxpayer are trades or businesses (Groetzinger, 480 U.S. 23 (1987)). (For more on this, see the Tax Clinic, "Exploring the Undefined: Trade or Business.")
Landlords with multiple properties who actively participate in the rental activities clearly have a trade or business in real estate and therefore qualify for the deduction. It gets murkier if, for example, the landlord owns one residential property and uses a property manager to handle all the activities. Most experts agree that triple net leases probably do not qualify as a trade or business (and they are not eligible for the Notice 2019-07 safe harbor), but even that situation should be reviewed, especially if the landlord owns and manages multiple triple net leases. Real estate trades and businesses are required to file Forms 1099-MISC, Miscellaneous Income, for vendor payments in excess of $600 and to complete the questions at the top of Schedule E, Supplemental Income and Loss, regarding the requirement to file the forms and whether they were filed. This could be problematic in defending a position that the activity rises to the level of a trade or business if Forms 1099-MISC were required to be but were not filed in previous years. Owners could also be subject to penalties for failure to file Forms 1099-MISC and for failure to supply copies to vendors.
Income from nonpassive rental arrangements (self-rentals) is defined as trade or business income under Regs. Sec. 1.1411-4(g)(6)(i), but this is usually commercial property rather than residential.
Each situation will have to be evaluated based on the facts and circumstances. Vacation homes are especially problematic, due to the profit motive requirement. And, since they are rarely profitable, such properties would more likely reduce the deduction rather than increase it. It is important to remember that none of the rules or classifications under Sec. 469 passive activity losses and credits apply when determining whether the property qualifies for the QBI deduction under Sec. 199A (Temp. Regs. Sec. 1.469-1T(d)(1)). However, Sec. 469(c)(7)(C) does define rental activities as "real property trades or businesses" in the context of passive activity losses. Sec. 1411(c)(2) concludes that a passive activity trade or business is subject to the net investment income tax, but this does not preclude it from being a trade or business. These references are possibly a hint as to congressional thinking regarding Sec. 199A and rental property treatment but cannot be relied upon.
Contributors Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas. Ms. Hagy is a member of the AICPA Tax Practice and Procedures Committee For more information on this article, contact firstname.lastname@example.org.
Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas. Ms. Hagy is a member of the AICPA Tax Practice and Procedures Committee For more information on this article, contact email@example.com.