Repairs vs. Capital Improvements on an Apartment Building: The IRS Rules for Syndications
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The IRS lets an apartment owner deduct the cost of repairs and maintenance in the year paid, but requires improvements to be capitalized and depreciated. Under the tangible property regulations, work is an improvement if it is a betterment, a restoration or an adaptation to a new use of the building structure or one of its building systems (plumbing, electrical, HVAC and the others). Three safe harbors let you deduct more: the de minimis safe harbor ($2,500 per invoice or item without an audited financial statement, $5,000 with one), the routine maintenance safe harbor and, for small buildings, the small taxpayer safe harbor.
This matters for a value-add syndication, because the business plan is mostly spending on the building. How the CPA classifies that spending changes the deal's taxable income, the K-1s investors receive and, at sale, the gain. This guide explains the tests with apartment examples. For the bigger tax picture, read apartment syndication taxes for beginners.
What counts as an improvement?
The IRS's tangible property regulations page sets out the analysis in steps.
Step 1: find the unit of property. For a building, the unit of property is the whole building, but the improvement tests apply to the building structure and to each key building system: plumbing, electrical, HVAC, elevators, escalators, fire protection and alarm, gas distribution and security.
Step 2: apply three tests. Work on the structure or a system is an improvement if it is:
- A betterment: it fixes a material condition or defect that existed before you bought it, adds to or enlarges the property, or materially increases its capacity, productivity, efficiency, strength or quality.
- A restoration: it replaces a major component or a substantial structural part, rebuilds the property to like-new condition after it fell into disrepair, or restores it after a casualty loss.
- An adaptation: it changes the property to a new or different use, such as converting apartments to offices.
If none of the tests applies, the cost is generally a deductible repair.
Apartment examples
These are typical classifications. Your CPA decides each one on its facts.
| Work | Likely treatment | Why |
|---|---|---|
| Patching drywall and repainting a unit between tenants | Repair | Keeps the unit in ordinary operating condition |
| Replacing a broken water heater in one unit with a similar one | Often a repair or de minimis | One small component of the plumbing system; under $2,500 an item can be expensed under the safe harbor |
| Replacing the whole roof | Improvement | Replaces a major component of the building structure |
| Replacing every HVAC unit in the building | Improvement | Replaces a major component of the HVAC system |
| Fixing foundation cracks the inspection found before closing | Improvement | Fixes a material defect that existed when you bought |
| Upgrading interiors with new cabinets, counters and flooring | Usually an improvement | Materially increases quality; parts may be personal property with shorter lives |
| Repaving the parking lot | Usually an improvement to land improvements | Land improvements are depreciated separately |
What are the safe harbors?
De minimis safe harbor. The deal company may elect to deduct amounts paid for property up to $5,000 per invoice or item if it has an applicable financial statement (for example, a CPA-audited statement), or up to $2,500 per invoice or item if it does not, as long as it expenses the same amounts in its books. The election is made each year by attaching a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed return. For a syndication, that means the partnership return, Form 1065. Write the policy down at the start of the year.
Routine maintenance safe harbor. Recurring work to keep a building system or the structure in ordinary operating condition is generally deductible if, when the system was placed in service, you reasonably expected to do it more than once during the 10 years after. Examples include inspecting, cleaning and replacing worn parts on HVAC equipment.
Small taxpayer safe harbor. A taxpayer with average annual gross receipts of $10 million or less, owning a building with an unadjusted basis of $1 million or less, may deduct all repairs, maintenance and improvements on that building for the year if the total is no more than the lesser of 2% of the building's unadjusted basis or $10,000. Most apartment syndications buy buildings above $1 million, so this one mainly helps small properties.
Why does deferred maintenance get capitalized?
Many value-add plans start with fixing what the seller let slide: roof leaks, failing plumbing, broken boilers. Under the betterment test, paying to fix a material condition or defect that existed before you acquired the property is an improvement. So the first-year "catch-up" budget is often depreciated, not deducted, even when each item looks like a repair. Ask your CPA to review the property condition report and your renovation budget before closing, so year-one projections use the right treatment.
Capitalized does not mean lost
A capitalized cost is depreciated. Residential rental buildings and their structural components are depreciated over 27.5 years, while some items inside units (such as appliances and certain flooring) and land improvements can have shorter lives and may qualify for bonus depreciation. A cost segregation study sorts them. See bonus depreciation for apartment syndications for the current rules.
When you replace a component, such as an old roof, the deal company may be able to make a partial disposition election and write off the remaining basis of the old component. Raise it with your CPA in the year of the replacement.
What it means for investors
Classification moves income between years. More deductions now mean lower taxable income on the K-1 in the early years and, through lower basis, more gain and possibly more depreciation recapture at sale. Explain the approach in your quarterly reports when it changes the numbers, and keep invoices organized so the CPA can apply the safe harbors.
How DoorRaise fits in
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FAQ
Is a new roof on an apartment building a repair or an improvement?
Replacing the whole roof is generally an improvement, because it replaces a major component of the building structure. Patching a leak is generally a repair.
Can a syndication use the de minimis safe harbor?
Yes. The deal company makes the election on its own return each year, with a written statement attached to its Form 1065, and applies the $2,500 or $5,000 limit per invoice or item.
Are unit turns deductible?
Ordinary make-ready work (cleaning, paint, small fixes) is generally deductible. A turn that replaces cabinets, counters and flooring as part of an upgrade is usually an improvement.
Do the rules change what investors pay in tax?
They change when income and deductions show up on the K-1, and therefore the timing of tax. Over the full hold and sale, much of the difference evens out through basis and recapture.
Next step: see how deductions reach investors in the K-1 in a real estate syndication.
Sources
- IRS: Tangible Property Final Regulations
- 26 CFR 1.263(a)-1, capital expenditures and the de minimis safe harbor
- 26 CFR 1.263(a)-3, amounts paid to improve tangible property
- IRS Publication 527, Residential Rental Property
- IRS Publication 946, How To Depreciate Property
This article is general information, not tax or legal advice. Classifications depend on the facts. Talk to a CPA about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.