Specialized Returns and Taxpayers · Rental property

Rental expenses (e.g., allocation between personal and rental, repair versus capitalized)

Every rental expense faces two gates. The first is allocation: how much of it belongs to the rental rather than to the owner’s own use, and whether the property was in service at all when the money was spent. The second is character: whether the payment restored the property to the condition it was meant to be in, which is deductible, or gave it something it did not have, which is not.

The rule

The authority to deduct (IRC § 212). an individual is allowed a deduction for all the ordinary and necessary expenses paid or incurred during the year for the production or collection of income, for the management, conservation or maintenance of property held for the production of income, and in connection with the determination, collection or refund of any tax (IRC § 212)^TY2026 A rental held for profit is usually a trade or business under IRC § 162 as well, but IRC § 212 catches the case where it is not.

A vacant property still deducts. ordinary and necessary expenses of managing, conserving or maintaining a building devoted to rental purposes are deductible notwithstanding that there is actually no income from it in the taxable year, and regardless of how or why the property was acquired (Treas. Reg. § 1.212-1(b))^TY2026 Being empty is not the test; being held out for rent is. That distinguishes a property between tenants, which deducts, from a property withdrawn from the market for the owner’s own use, which does not.

When the clock starts. the period for depreciation begins when the asset is placed in service and ends when it is retired from service, with a proportionate part of one year’s depreciation allowable for the part of the first and last year during which it was in service — for a rental property, placed in service means held out and ready for rent, not first occupied (Treas. Reg. § 1.167(a)-10(b))^TY2026 A rental property is placed in service when it is ready and available to be rented, not when a tenant moves in — so depreciation runs during a vacancy that follows availability, and does not run during the refurbishment that precedes it.

Before that, IRC § 195. a start-up expenditure is an amount paid in connection with investigating the creation or acquisition of an active trade or business, creating one, or any activity engaged in for profit and for the production of income before the active trade or business begins in anticipation of its becoming one — and which would be deductible if paid in connection with an existing business in the same field; it excludes amounts deductible under IRC §§ 163(a), 164, 174 or 174A (IRC § 195(c)(1))^TY2026 Costs of investigating and creating the rental activity before it begins are start-up expenditures, not current deductions, and the acquisition costs of the property itself go to basis rather than either.

Allocation for mixed use. where a dwelling unit is used for personal purposes on any day in the year, deductions for expenses attributable to the rental may not exceed the proportion that the days rented at a fair rental bear to the total days the unit is used (IRC § 280A(e))^TY2026 where the unit is used as a residence, deductions attributable to the rental use may not exceed the gross income from that use less the deductions allocable to it that are allowable whether or not the unit was so used, and less the deductions allocable to the activity but not to that use; the disallowed amount carries forward to the succeeding year and is subject to the same limit there, whether or not the unit is a residence in that later year (IRC § 280A(c)(5))^TY2026 Where the property is also used as a residence, the day-count allocation comes first and the gross income cap second.

Repair against improvement. a unit of property is improved if the amounts paid for activities performed after it is placed in service are for a betterment to it, restore it, or adapt it to a new or different use^TY2026 That single test — betterment, restoration, or adaptation to a new or different use — decides the character of every amount spent on the property after it is placed in service.

Applied to what. each building and its structural components is a single unit of property, but the improvement rules are applied separately to the building structure and to each of the designated building systems^TY2026 heating, ventilation and air conditioning; plumbing; electrical; all escalators; all elevators; fire-protection and alarm; security; gas distribution; and any other structural component designated as a building system in published guidance — the building structure being separate from all of them^TY2026 The building systems list is the reason a rental is harder than it looks: replacing a component is measured against the system, not against the whole building, so a new furnace is judged against the heating system rather than against a building worth twenty times as much.

The three limbs. three tests, any one of which capitalises: the amount ameliorates a material condition or defect that existed before acquisition or arose during production, is for a material addition or a material increase in capacity, or is reasonably expected to materially increase productivity, efficiency, strength, quality or output^TY2026 six tests, any one of which capitalises: replacing a component for which a loss was deducted; replacing a component whose adjusted basis was taken into account on a sale or exchange; restoring damage requiring a casualty basis adjustment; returning property from a state of disrepair to ordinarily efficient operating condition; rebuilding to like-new condition after the end of its class life; or replacing a major component or substantial structural part^TY2026 an amount is paid to adapt property to a new or different use if the adaptation is not consistent with the taxpayer’s ordinary use of that property at the time it was originally placed in service by the taxpayer^TY2026

Three ways out. $2,500 per invoice, or per item as substantiated by the invoice — where the taxpayer has no applicable financial statement, had accounting procedures in place at the beginning of the year, and treats the amount as an expense on its books and records. The figure printed in Reg. § 1.263(a)-1(f)(1)(ii)(D) is $500; Notice 2015-82 raised it to $2,500 for costs incurred in taxable years beginning on or after 1 January 2016^TY2026 a qualifying taxpayer may elect not to apply the improvement rules to an eligible building property where the total paid during the year for repairs, maintenance, improvements and similar activities on it does not exceed the lesser of 2 percent of its unadjusted basis or $10,000^TY2026 average annual gross receipts for the three preceding taxable years of $10,000,000 or less, and an eligible building property with an unadjusted basis of $1,000,000 or less — the unadjusted basis being determined without the IRC § 1016(a)(2) or (3) adjustments and without regard to any IRC § 179 expensing^TY2026 recurring activities expected to keep the building structure or a building system in ordinarily efficient operating condition, including inspection, cleaning, testing and replacement of worn parts with comparable ones — routine only where the taxpayer reasonably expects to perform them more than once in the 10 years beginning when that structure or system was placed in service^TY2026 in applying the small taxpayer ceiling, amounts not capitalised under the de minimis election and amounts deemed not to improve property under the routine maintenance safe harbor are counted toward it^TY2026

And a partial disposition. a taxpayer may elect to treat the retirement of a portion of an asset as a disposition, recovering the remaining basis of the replaced part, by the due date including extensions of the original return for the year of disposal^TY2026

Current figures

How it works in practice

Fix the placed-in-service date before classifying anything, because it separates two entirely different regimes. Money spent before the property is ready and available for rent is generally capitalised into basis — it is part of getting the asset into condition for its intended use — and depreciation has not begun. Money spent afterwards is tested under the improvement rules, and much of it is deductible. A landlord who buys a derelict house, spends nine months restoring it and then advertises it, has capitalised the whole of that spend whatever the work looked like item by item.

For a mixed-use property, do the day allocation before anything else and use the right denominator — days the unit was used, not days in the year. Then apply the improvement rules to the rental share. An improvement to a mixed-use property is capitalised in full and depreciated on the rental percentage; it is not split into a deductible personal half and a capitalised rental half.

On repair against improvement, work from the unit of property outwards. For a building, the unit is the building and its structural components, but the improvement rules are applied separately to the structure and to each of the nine building systems. That makes the question “is this a betterment or a restoration of the plumbing system” rather than “of the building,” which is a much lower bar and capitalises far more than landlords expect. Replacing all the windows, all the wiring or the whole roof membrane is usually a restoration of a major component.

Then reach for the safe harbours in the right order, because they interact. The de minimis election is applied first and takes small invoices out entirely. The routine maintenance safe harbour covers recurring work expected more than once in ten years for a building. The small taxpayer election is the most useful for a modest portfolio, but its ceiling counts the amounts already removed by the other two — so a landlord who has used the de minimis election has less room under it, not more.

How this has changed

The tangible property regulations at Treas. Reg. §§ 1.263(a)-1 through -3 were finalised in September 2013 and generally apply to taxable years beginning on or after 1 January 2014. They replaced a body of case law running back to Illinois Merchants Trust and gave landlords, for the first time, a structured test and three safe harbours. They also introduced the building systems concept, which capitalises considerably more than the old “does it materially add to value or appreciably prolong life” standard did for a building.

The de minimis threshold for a taxpayer without an applicable financial statement was raised five-fold by Notice 2015-82, effective for costs incurred in taxable years beginning on or after 1 January 2016, and the notice extended audit protection to earlier years at the higher figure. for a taxable year beginning before 1 January 2016 the Service will not raise the issue on examination where the taxpayer otherwise satisfies Reg. § 1.263(a)-1(f)(1)(ii) and the amount does not exceed $2,500 per invoice or per item, and will not further pursue an increase already under consideration on that basis (Notice 2015-82, Audit Protection)^TY2026 That change did more for small landlords than any other single element of the regulations, and the regulation itself still prints the old number.

The partial disposition election was the other major practical addition. Before it, a landlord replacing a roof capitalised the new roof while continuing to depreciate the old one, permanently. The election allows the remaining basis of the replaced component to be recovered in the year of replacement, and it must be made by the due date of the return for that year.

For mixed-use property nothing in IRC § 280A has changed, but the value of the personal half of the allocation fell when the state and local tax deduction was capped and the standard deduction rose, so the Bolton allocation question — whether interest and taxes are apportioned over days used or over the whole year — now matters more to the arithmetic than it used to.

Exam focus

Know that placed in service means ready and available for rent, that pre-service costs are capitalised regardless of their nature, and that a vacant property held out for rent continues to deduct and to depreciate.

Know the improvement test as three limbs — betterment, restoration, adaptation — and know that for a building it is applied to the structure and to each of the nine designated systems separately. Be able to name the systems.

Know the three safe harbours, their thresholds, and that the amounts removed by the first two count against the small taxpayer ceiling. Know the day-count allocation for mixed use and that its denominator is days used.

Check yourself

1. A landlord’s rental is empty for four months while she looks for a tenant, having advertised it throughout. May she deduct the insurance and depreciation for those months?

Answer: Yes to both. Treas. Reg. § 1.212-1(b) allows expenses of maintaining a building devoted to rental purposes notwithstanding that there is no income in the year, and the property remains in service for depreciation because it is held out and available for rent. Vacancy is not the test; withdrawal from the rental market is.

2. An investor buys a house in March, refurbishes it through August, advertises in September and lets it in November. When does depreciation begin, and what happens to the refurbishment cost?

Answer: Depreciation begins in September, when the property is ready and available for rent. The refurbishment cost is capitalised into the basis of the building, because it was incurred before the property was placed in service and is part of putting the asset into condition for its intended use. The November occupancy is irrelevant to both answers.

3. A landlord replaces the entire roof covering of a rental building. Is that a repair?

Answer: No. Under Treas. Reg. § 1.263(a)-3(k) it is a restoration — the replacement of a major component or substantial structural part of the building structure — and must be capitalised. The routine maintenance safe harbour does not save it, because that safe harbour never covers a restoration of a major component. The landlord should consider the partial disposition election to recover the remaining basis of the old roof.

4. A property is rented at fair rental for 150 days, used personally for 30 days, and vacant for the rest of the year. What proportion of the utilities is allocable to the rental?

Answer: 150/180, or about 83.3 percent. IRC § 280A(e) compares days rented at a fair rental to the total days the unit is used, which is 180. The vacant days appear in neither figure. Note that the personal use of 30 days also exceeds the greater of 14 days or 10 percent of 150, so the gross income cap in IRC § 280A(c)(5) applies on top of the allocation.

5. A landlord with average annual gross receipts of $600,000 owns a rental with an unadjusted basis of $180,000. She spends $4,000 on repairs, $1,200 on maintenance and $900 on improvements during the year. Can she elect out of the improvement rules?

Answer: Only if the total is inside the small taxpayer ceiling, which is the lesser of two amounts — one a fixed dollar figure and the other a small percentage of the unadjusted basis. Her total spend of $6,100 must be tested against that ceiling, and if it exceeds it the election is unavailable for the year and the $900 of improvements must be capitalised. Note that anything she has already removed under the de minimis election still counts toward the $6,100 for this test.