[00:00:00] Hi, everyone. This is the how to lower your tax bill 
[00:00:10] podcast. I'm your host, Terrence Hutchins. I'm, a financial and tax advisor in the Dallas Fort worth area. And the goal of this podcast is to help you listeners get 
[00:00:20] educated on different tax strategies. That you can implement to improve your tax situation immediately? Each episode, we'll break down useful tax tips you can use to 
[00:00:30] save money no matter what your personal or business income situation. Because our motto is keep more of what you earn. So let's get into today's 
[00:00:40] episode. So welcome to episode 13 of the How To Lower Your Tax Bill 
[00:00:50] Podcast. We've been going through a series related to real estate And some of the different tax treatment or, strategies that you have when you own rental 
[00:01:00] properties, as a W-2 employee or as a real estate investor. And so in today's episode, we're going to talk about one of the important topics related to [00:01:10] repairs.So we're going to help you understand the IRS rules on repairs versus improvements. You're going to learn why repairs are better than improvements as it 
[00:01:20] relates to your current taxes. We're going to help you get familiar with the three IRS safe harbors that can help you maximize your deductions. And then you'll be able to determine if an expense 
[00:01:30] qualifies as a repair not.And then we'll give you a court case that will speak to how the IRS views this in their Compliance of the rules. 
[00:01:40] Now when it comes to repairs, one of the things that I always want to point out to investors is whenever you're underwriting a property, it's important that you add in a repair as an 
[00:01:50] expense that you are going to realize, but you may not.
And normally I'll do that at 5 to 10 percent of the rent value, but that also depends 
[00:02:00] on the property itself. And so you'll want to think, all right. I'm going to have general maintenance, especially if you have aolder home where in today's environment where cash flow is a little harder 
[00:02:10] to get, you will haveprobably the opportunity to buy an older house where the cash flow might be better, but you're going to have to factor in the cost 
[00:02:20] of the repairs or potential improvements that you're going to have to make and how that's going to impact your investment return. many times I see investors where they fall in love with their property, they never want to sell [00:02:30] it, but it always gives them problems. And so if you're not evaluating the actual net returns you're getting, and we've talked about the idea of your return on equity, looking at the 
[00:02:40] income compared to the equity every year. These repairs will add up, they'll take away your cash flow, and then you'll have a property, especially if it's older, that's not really appreciating in value, 
[00:02:50] but you hold on to it, and then it becomes a bad investment over time, or, the opportunity cost of holding on to that investment really prevents you from growing your wealth in a more 
[00:03:00] meaningful way.So, as it relates to the tax portion of this, a repair versus improvement, a repair are necessary expenses to keep the property in good operating 
[00:03:10] condition,   and you can actually deduct them in the year that they happen. this would be something like a leaky roof, replacing a few broken shingles, patching holes in their drywall, or 
[00:03:20] repairing a broken sink.Many times these are things your tenant is going to be calling you about to come and fix, and you'll send someone out to get that done. and hopefully as you 
[00:03:30] are thinking about your material participation, either you're overseeing this time. So this would be direct hours to operating the property where you're going and doing it yourself.
So you want to track 
[00:03:40] the time that it takes to do those so that you can make sure those hours are captured throughout the year, but it also gives you an idea of how much time you're spending on each of your rentals. And then you can also [00:03:50] compare that to the return for each because once again, if you have an older property that you're having to spend a lot of time on, then you should expect a higher return from it. So if you ever spent a lot of 
[00:04:00] time and the returns aren't good, then that should even motivate you further to think of this something that you want to go ahead and in the future. An improvement on the other hand must 
[00:04:10] be capitalized, which is just a fancy word to say that the cost of what you pay has to be spread out over the life of the property, which in this case is 27 and a half years. So 
[00:04:20] you're basically going to adding the cost of the improvement to the value of the property. So this could be like replacing the whole roof, installing a new HVAC system, or adding a room or additional square 
[00:04:30] footage. So many times these are going to be things that you'll do in between tenants or you'll do to kind of get the property ready to be rented out in the first place. So repairs are better because you
[00:04:40] could deduct the cost of them immediately. So instead of me spending, you know, $4,000 on something and having to spread it out over 20 plus years, I can actually deduct 
[00:04:50] that $4,000 in the first year. Which as we've talked about in the past, the time value of money, a dollar today is worth more than a dollar tomorrow.
So if I can save more taxes today, I'll have more 
[00:05:00] cash available to reinvest in other things to where I can grow my wealth faster. Plus, recall whenever you are depreciating the item, Or when you have an 
[00:05:10] improvement, remember you're deducting it year over year. So that means when you sell the property, you actually are gonna recapture that tax, which is an important component.
'cause if you buy a property and you put a lot of money 
[00:05:20] into it, I would much rather be able to deduct it and never have to pay tax on that again. Versus if I do an improvement, I get a tax deduction but I potentially may have to repay that back with the 
[00:05:30] depreciation recapture in the future. Also, it's important to factor that any improvement you do does need to be added to the value of the property, which 
[00:05:40] can reduce the future tax on the sale. So if I buy a property for $100,000 and I put $50,000 of work into it, the tax value is $150,000, not factoring 
[00:05:50] in depreciation. If I sell it for $200,000, I want to only pay tax on $50,000 which factors in the improvements versus paying taxes on 100, which would be the original purchase price. 
[00:06:00] So this is important to keep track of these over time.
So you'll eventually lower your capital gain down the road. Now let's get into the three safe harbors or what I would call your get out 
[00:06:10] of jail free cards. So these are things that the IRS created to help simplify whether you can take an expense now or you have to spread it out. So you have three different ones. One is going to 
[00:06:20] be the safe Harbor for small taxpayers. So this has a few requirements. Number one, the property has to be below a million dollars, which is majority of houses out there, at least in 
[00:06:30] the rental market, the annual expenses for repairs, maintenance, and improvements must not exceed the lesser of $10,000 or 2 percent of the buildings basis.
[00:06:40] So. If you buy the property, you got to think, okay, what did I buy it for? And my deduction, I could take 2 percent of that, or I can take $10,000, which once I get over a 
[00:06:50] $500,000 property, I'm going to be capped out at $10,000. So if I have a sub $500,000 property, I definitely want to take any expense up to the $10,000, that I spend in 
[00:07:00] that dynamic. So for example, if I have a 200, 000 property. 2 percent of that is for a grand, so if I have a 3, 500 expense, I can actually just take that in the first 
[00:07:10] year versus having to spread it out. So that's the small taxpayer safe harbor. The second one is what we would call the routine maintenance safe harbor. So this covers reoccurring 
[00:07:20] maintenance to keep the property in working condition. So there actually is no spending limit on this, but the expense that you have are something that you would think, hey, I'm going to have to do this at 
[00:07:30] least once every 10 years. So it's not really improving the property. I might just have to replace this item, but I'm not, going to be doing it on a very frequent basis. So 
[00:07:40] this could be like maybe the HVAC system inspections and filter replacements, replacing your gutters. Or servicing the gutters, uh, like your smoke detectors, 
[00:07:50] uh, patching the interior walls. It could be like your water heater flushing and like minor plumber repairs. it could be inspecting or replacing broken window 
[00:08:00] locks or chimney cleanings, pest control treatments, roof inspections.
So those are things that would qualify to say, hey, I could spend 12 grand potentially on these items, 
[00:08:10] but I might have to do this every 10 years. And so since I have to do it every 10 years. I can actually just take the cost of that expense right now.so for example, if you know you owned an apartment 
[00:08:20] building and you hired a contractor to clean and inspect your HVAC system and you have to do that every four years, then that cost would count as a routine maintenance. So in this case, 
[00:08:30] you actually don't have to make an election but on the safe harbor, you do, which just means that you have to attach a statement to your tax return that you're basically making that election on your tax return and say, Hey, this is what I'm doing. This is 
[00:08:40] why I was able to deduct these repairs in the first year. Now, your third one is called the de minimis safe harbor. So that just means, and we've talked about this before, but if you have an 
[00:08:50] item that is $2,500 or less, for each specific item, then you can actually deduct it in the first year, regardless of how many items you have.
So this is generally going to look 
[00:09:00] at appliances, fixtures, and supplies. Now this you do have to attach a statement to your tax return. So for example, let's say you had a duplex and you were replacing the dishwashers 
[00:09:10] and you were replacing the ovens or the refrigerators. And all those items individually were less than $2,500. So let's just say, you know, you had to replace six of them and you end up 
[00:09:20] spending $12,000 well, you could take that 12, 000 upfront because all the individual items were less than 2, 500. So that gives you the ability to get that 
[00:09:30] tax break because of the de minimis safe harbor. Now, you do have to attach this election to your tax return for each year that you're doing it just to make sure that you're covering your basis 
[00:09:40] and then you just want to keep records on what individual items you bought and then that will also speak to, okay, how often do I have to replace the refrigerator? How often do I have to replace the dishwasher? That can kind of give you an 
[00:09:50] idea because when you buy it, it's good to get that information from your salesperson or your customer service rep there. But having the actual data for your properties is also very 
[00:10:00] effective because that will give you the ability to price that in to future properties. Now, before we wrap today's episode, I want to talk about something that's often overlooked 
[00:10:10] whenever people are doing improvements. And that is how they treat the replacement of the building components that they just had. So, for example, if you're having to replace a 
[00:10:20] roof or an HVAC system or even windows. When you get rid of those items. Most people don't know how to handle that from a tax perspective. Now in the past, the [00:10:30] IRS would require a landlord to continue to depreciate the old component even after they replaced it. So if you replaced your roof, you would still depreciate the old 
[00:10:40] roof and then you would start depreciating the new roof. So you basically depreciating two roofs at the same time. One of them that actually didn't exist anymore. So in 2014 they decided 
[00:10:50] to make this adjustment. And they gave you two options when it came to, well, how do you treat the component of your property that you've gotten rid of? So number one, you could continue to 
[00:11:00] depreciate the old component. You basically don't do anything and you're not really reporting. That isn't normally a great option. the second Option would be to deduct the 
[00:11:10] remaining cost of the old component. This is called a partial disposition election. So you basically can deduct the value of that item that you [00:11:20] replaced as a tax loss on your tax return.  So you don't really make any special elections per se, but you're actually just reporting it as You've gotten rid 
[00:11:30] of that component. So let's just say, you know, we've been talking about roofs and you have a commercial property that you own and you have to replace the roof on it.
Well, the new 
[00:11:40] roof, you're going to depreciate that over the life of the property. So if it's a commercial property, you're going to depreciate it over 39 years. Now, the old roof, it doesn't exist 
[00:11:50] anymore. So you're going to have to try to determine, okay, what was the value of that roof? And you can look at, what was the original price that you paid?
So if you have the original invoice, you can kind of look at 
[00:12:00] that. You can look at the producer price index to adjust for inflation for this. Okay. Hey, when was this roof purchased? And, what are roofs going for now? And I can kind of 
[00:12:10] adjust for inflation and determine what was the cost of the roof at the time it was put in place.
You can do a cost segregation study. for example, if you see, all right, I have a [00:12:20] new roof that's $10,000 and you look at the producer price index and you determine, all right, the old roof that I just got rid of was probably worth $7,500 bucks at the 
[00:12:30] time that it was purchased. I've been taking depreciation.
And so the value of it now was 4, 000. Well, now that 4, 000. The value of it is. [00:12:40] Currently zero because you just got rid of it. So if you got rid of a 4, 000 component, you can actually deduct that as a tax loss. So you would just report it as 
[00:12:50] a business loss on like form 4797. So that's actually something that if you are making improvements and you are getting rid of some of the parts of your property, you would want to take 
[00:13:00] advantage of those tax losses. And the good thing is those are considered ordinary losses on a Investment property so you can actually deduct the full value of it against your income So that's 
[00:13:10] a thing to keep in mind Now there was a tax court case called la pointe versus commissioner this was in 1990 when it actually happened but [00:13:20] Originally, Dorothy LaPointe, she owned 13 rental properties and they made different renovations to three of them back in 1983, and they deducted them as 
[00:13:30] repairs.
And so the renovations included, they replaced the furnace, they erected a fence, they replaced the roof, they installed fixtures, drapes, a garage door, a greenhouse, a window, a  
[00:13:40] sink and a counter, flooring and carpeting. And the tax court held that these expenses were capital expenditures and they must be added to her basis. So she tried to deduct them in the first 
[00:13:50] year. She didn't use any of the safe harbors. So the IRS basically threw out her deductions and reduced them and said that she needed to have added them to the basis and spread them out over the 
[00:14:00] life of the property. So this is important that, okay, just because you spent $25,000, if you write that $25,000 off, then you need to make sure it falls under one of the 
[00:14:10] safe harbors, or you're going to have to individually itemize out how did you spend the $25,000. what is gonna be considered a repair? What is gonna be considered an improvement? a good rule of 
[00:14:20] thumb to determine this is to ask yourself three questions. Number one, does the expense add value to the unit of property? Meaning does the expense materially 
[00:14:30] increase the value of the property? It's likely an improvement. It must be depreciated. If it restores the property to its previous condition. without adding value. It's 
[00:14:40] likely a repair. So if you're saying, okay, here's this item, I just need to get back to replacement value, That might just be a repair. Number two, does the expense 
[00:14:50] adapt the unit of property to a new or different use? So if you are modifying your investment property to serve a different function, like you're converting a garage into a room or something like 
[00:15:00] that, That's going to be an improvement. If the work maintains the property for its current use, that's likely a repair. So I, you know, I had a hole in the wall. I basically passed up the wall.
[00:15:10] That's considered a repair. Versus I moved. I basically knocked that wall down so I can expand my square footage. And then thirdly, does this expense substantially 
[00:15:20] prolong the useful life of the unit of property? So if it allows me to extend how long the property can be used, it's probably an improvement.
Or if it just restores the property to its original function, 
[00:15:30] it's probably a repair. OK, so you can kind of just go through a few examples and think, all right, if I'm replacing a shingle, does it add value? No. [00:15:40] Does it adapt to a new use? No. Does it prolong the useful life? No. And that's probably a repair. Okay. So if you go through that checklist, that'll be a good barometer on a repair or an 
[00:15:50] expense. All right. So if you have any questions, you can reach out to us at questions at logosfg.com We can get back to you on this 
[00:16:00] topic or any other tax related topic that you have. So as we always say, keep more of what you earn and we'll talk to you guys next week.