New Depreciation Regs effective 1/1/2012 apply to ROOFS

IRS has issued temporary regulations to help clarify when an expenditure is a capital improvement or a repair as well as clean up a few other issues. Broadly speaking they are trying to integrate the basic rules and concepts that have been developed over the years in court cases and IRS guidance for distinguishing capital expenditures from currently deductible repairs. Specifically I’m referring to the “expense or depreciate” decision for a new roof, although I’m sure you guys will find new and clever ways to apply these rules to your real estate business.

CAUTION! These are “temporary” regs at this time, so things could change. Also, note that there are no “bright line” tests, so facts and circumstances will continue to play an important role in deciding deductibility.

Regs start here. My comments are in italics

A unit of property is improved if amounts are paid for activities performed after the unit of property is placed in service by the taxpayer, resulting in:

  • A betterment to the unit of property;
  • A restoration of the unit of property; or
  • Adaptation of the unit of property to a new or different use

“Unit of property” is a new concept. In general, a rent house would be considered a unit of property. However, when dealing with multi-unit properties, many repairs (roof, common area repairs) might apply to several “units of property.”

Betterment: A capitalized betterment is an expenditure that:

  • Ameliorates a material condition or defect that existed prior to the taxpayer’s acquisition of the unit of property whether or not the taxpayer was aware of the condition or defect at the time of acquisition;
  • Results in a material addition (for example, physical enlargement, expansion, or extension) to the unit of property; or
  • Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property

This is list is pretty self-explanatory, except for the first item. In this case, if you purchased a house with a 15 year old roof, replacing the roof is ameliorating a condition that existed at the time of purchase and would be capitalized (the theory is that the condition of the roof would have been reflected in the purchase price). If the roof was 2 years old at purchase, and you replaced it 13 years later, you would be repairing the degradation of the roof that had occurred since purchase, which would be a repair expense. However, if the roof was 15 years old but was in servicable condition at purchase, and subsequently was storm damaged the year after you purchased the house, then you are repairing damage incurred after purchase, which is also deductible as a repair. Got it?

The replacement of a part of a unit of property with an improved but comparable part does not, by itself, result in a betterment to the unit of property if it is not practical to replace the part with the same type of part (for example, because of technological advancements or product enhancements)

Restorations: An amount paid to restore a unit of property if:

  • A component of the unit of property is replaced and a loss is deducted or a gain or loss is realized by selling or exchanging the replaced component;
  • A casualty loss resulting in any basis adjustment is claimed on the repaired unit of property;
  • The expenditures returns a unit of property to its ordinary efficient operating condition after the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
  • The expenditures rebuild a unit of property to a like-new condition after the end of its class life; or
  • The expenditures are for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.

Major repairs after a fire or other loss, or a full rehab to make a property like-new after the end of its useful life are capitalized. Note that even though you would use the same materials and supplies (drywall, paint) to perform both repairs AND a rehab, the costs of those components must be capitalized as an improvement under the rules for restorations and may not be deducted as a material or supply

Adaptation to a new or different use is a type of improvement that is capitalized. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer’s intended ordinary use of the unit of property at the time it was originally placed in service by the taxpayer.

Example: converting a single family home to a duplex or a commercial office.

Routine Maintenance Safe Harbor

The costs of performing certain routine maintenance activities are currently deductible under a routine maintenance safe harbor. Under the safe harbor, an amount paid is deductible if it is for ongoing activities that a taxpayer expects to perform as a result of the taxpayer’s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. The activities are routine only if, at the time the unit of property is placed in service, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property

Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of parts with comparable and commercially available and reasonable replacement parts.

Factors to be considered in determining whether a taxpayer is performing routine maintenance include the recurring nature of the activity, industry practice, manufacturers’ recommendations, the taxpayer’s experience, and the taxpayer’s treatment of the activity on its applicable financial statement.

The safe harbor does not apply to the cost of replacing components if a retirement loss is claimed, gain or loss is realized upon a sale, or a deteriorated and nonfunctional property is restored to its ordinarily efficient operating condition.

[i]You could probably also deduct a new roof as a repair under this provision.

Questions? I’m available for consultations regarding your specific circumstances. But at least it does provide some basis you can use to argue your case if you take a positon and it comes up under audit. Print this (or locate the actual Temp. Reg. §1.263(a)-3T online and print those, too) and put it in your files just in case. And good luck![/i]

Just read your treatise about the new regulations, thanks for keeping us informed.

If I got it right, restoration of a property and costs incurred by changing the use of a property are capitalized. That means that you can not deduct those expenses off your taxes all in one year. Instead your accountant must put that cost on a depreciation schedule and only a portion is deducted each year.

Uhm, that means that the 1-bedroom unit that we converted to a 2-bedroom unit by stealing 1 bedroom from the adjacent unit would have capitalized expenses? How about the 2nd unit that lost square footage? De-capitalized?!


the 1-bedroom unit that we converted to a 2-bedroom unit by stealing 1 bedroom from the adjacent unit would have capitalized expenses?


How about the 2nd unit that lost square footage? De-capitalized?

No. You didn’t get a refund. You incurred more costs. Those costs are capitalized.

Unit 2’s cost is still the same, thus the depreciable basis is the same. I suppose if you were to get a new appraisal you would have justification for shifing cost basis from unit2 to unit1. But this just moves the depreciation around a bit; it doesn’t change the total cost of the two units overall.

I see. Very interesting.

Is it common to get audited for expenses vs. depreciation? I thought it was more of an election of the owner.


no, there’s not much wiggle room in depreciation when you’re dealing with property basis.

audits on this are not common (I’ve never seen one) but keep in mind the danger is that depreciation is long term… and you can only amend back 3 years. If you ARE audited in year 27, you cannot go back and change all those early years that the depreciation was incorrect. gotta get it right at the front end.

I was just audited last month and the auditor wanted to see the basis for depreciation for my properties and capital improvements, some going back 8 years, as well as the depreciation tables, and also “maintenance and repairs”.

Luckily I keep pretty good records. Per my accountant the auditor is preparing to issue a “no change” letter but it cost me around $1200 for the accountant to handle the audit.