Expensing Safe Harbor Options - resizedThe Tangible Property Regulations brought a great deal of confusion and chaos in the wake of their arrival.  Things were pretty rough, and some of us are still having Rev. Proc.-related nightmares.  However, there’s a rainbow behind this storm, and the TPRs have established three new expensing options that may add quite a bit of color to your tax returns going forward.

The three Safe Harbor elections are:

  • De Minimus Safe Harbor
  • Safe Harbor for Small Taxpayers
  • Routine Maintenance Safe Harbor

This blog post approaches the subject from a real estate perspective.  So, if you’re a property owner or you represent one, pull up a chair – you’ll want to read on.

De Minimus Safe Harbor §1.263(a)-1(f)(1)(i), & (ii)

The De Minimus Safe Harbor allows for the deduction of certain amounts paid to acquire tangible property at two different levels.  Taxpayers with applicable financial statements (AFS) can deduct up to $5,000 per item or invoice.  Remember, an AFS is a financial statement that is required to be filed with the SEC, or a certified audited financial statement used for credit or reporting purposes, or a financial statement required to be provided to the federal or state government (other than a tax return).  But having an AFS is only part of the deal – to take advantage of this level of the De Minimus Safe Harbor election, taxpayers also need to have a written policy in place that treats said amounts as expense for non-tax below a certain dollar amount or treats assets with a life of 12 months or less as an expense.   This policy has to be in place the first day of the tax year in which it is to apply.  This is an election, not a change in accounting method, and as such does not require the filing of a Form 3115.  Accounting treatment needs to be consistent for both book and tax purposes.

Let’s say you buy 10 shiny new PTAC units for your apartment building at $1,000 each, for a total of $10,000 (all itemized on a single invoice).  If you have an AFS, a written policy in place, and an itemized invoice, you’ve got yourself a $10,000 deduction.

If you don’t have an AFS, you can still benefit from the De Minimus election, though at a significantly lower level.  Non-AFS taxpayers can deduct up to $500 per item or invoice.  This is a great way to deduct low-cost items.  Did you buy a few $450 refrigerators for apartments undergoing improvements at turnover?  You’ve got a few solid expenses.  The non-AFS taxpayer also needs to have a procedure in place at the beginning of the tax year with content comparable to that described above.  However, this policy doesn’t have to be in writing.

Safe Harbor for Small Taxpayers §1.263(a)-3(h)

Score one for the little guy.  This election is only available to taxpayers with gross receipts below $10 million for the last three years, and only applies to buildings with an unadjusted basis of less than $1 million.  Eligible candidates can deduct either $10,000 or 2% of the unadjusted basis of the building, whichever is less. This is also considered an election, with no Form 3115 required.

Let’s say you own a cozy rental property on the Jersey shore, and its unadjusted basis is $300,000.  2% of that unadjusted basis is $6,000, which is clearly less than $10,000, and would therefore represent the maximum deduction possible here.  Imagine that repairs and maintenance on your little nest egg generally run $2000 yearly.  This year though, all the washer/dryers needed to be replaced at an additional cost of $3000.  Therefore, the total maintenance amount this year is $5,000, which is less than 2% of the building’s unadjusted basis, and can therefore be deducted in full under the Safe Harbor for Small Taxpayers.

There is one caveat however, and it is a significant one.  The maximum deduction allowed under the Safe Harbor for Small Taxpayers includes all repair-related deductions in that tax year.

DeMinimus Safe Harbor deductions +

Routine Maintenance Safe Harbor deductions +

Safe Harbor for Small Taxpayers deductions =

               MAX of $10,000 or 2% of basis

            Yes, it’s cumulative, and in that sense it is potentially limiting.  However, the right advisors (i.e. the Capstan team and your CPA) can help you choose the best way to mix your expenses and maximize your benefit.

Routine Maintenance Safe Harbor §1.263(a)-3(i)

This one is a special favorite here at Capstan, as it can be used by any landlord, regardless of income, property size, or AFS-status. Under this Safe Harbor, taxpayers can deduct amounts spent on routine maintenance with no cap.  Routine maintenance is a “preventative or cyclic maintenance that is an essential part of the ongoing care and upkeep of a building and its systems.”  Things like inspecting, cleaning, testing, and replacing worn assets with comparable ones fall under this heading.  Any replacement that improves the property, however, is not eligible.  (Improvements, betterments, etc. certainly have their own place under the TPRs, but that’s a subject for a different blog post.)

To be considered “routine,” the activity has to be one that you expect to repeat at least once every 10 years.  Sealcoating your parking lot every four years?  Sure.  Replacing a worn out roof every two decades?  Forget it.  Even If the activity doesn’t end up being required decennially, the IRS will still be on board if it was reasonable to expect that the activity would have been required based on your previous experiences.

Let’s return to our friend on the Jersey shore and imagine that he had a terrible year, a year in which everything seemed to go wrong, and a subsequent maintenance amount of $8,000.  This exceeds 2% of the building’s unadjusted basis ($6,000) and our friend could therefore only deduct ¾ of his expenses under the Safe Harbor for Small Taxpayers.  If the cumulative expenses go over the $6,000 cap, he would lose the Small Business Safe Harbor altogether.  Fortunately, in this particular scenario he could deduct all his expenses under the Routine Maintenance Safe Harbor.

Each Safe Harbor has its own boundaries, and there is an interplay between them as well.  They are best employed strategically by a tax professional well-versed in maximizing their utility.  To learn more, why not attend one of our upcoming webinars on the subject?  Want to talk one-on-one?  Contact Terri Johnson or Bruce Johnson at 215.885.7510 or through our website.   We look forward to connecting with you!